WHY THE FED WILL STRUGGLE TO STAY ABOVE THE FRAY / THE FINANCIAL TIMES COMMENTARY & ANALYISIS ( RECOMMENDED READING )

Why the Fed will struggle to stay above the fray

By Sylvester Eijffinger and Edin Mujagic

Published: October 4 2009 21:24

Much has been written lately on the decision by President Barack Obama to nominate Ben Bernanke for a second term as chairman of the US Federal Reserve. Some argued that had Mr Obama chosen otherwise, it would have signalled that the political independence of the Fed was under threat. However, we feel that the dangers for the Fed are not over yet.

Empirical research shows that central bank independence is of the utmost importance to having low and stable inflation. There is a clear correlation between lower inflation and more central bank independence. The explanation for this is that politicians tend to create too much liquidity when they have the opportunity to do so. In the medium to long term, too much liquidity ultimately results in excessively high inflation.

Although many argue that the Fed is an independent central bank, we do not agree. The Fed is independent within government and, as such, only partially so. The Federal Reserve Act may be changed by a simple majority in the US Congress. The statutes of the European Central Bank, by contrast, can only be changed if all 27 European Union member states agree. This would surely be a complicated process as countries such as Germany and the Netherlands can be counted on always to resist such a move.

In the first place, the nomination of Mr Bernanke for a second term is not a cause for relief regarding threats to the Fed’s independence; on the contrary, it is more a sign of distress. Under his leadership, the central bank’s independence has suffered. Examples of this are the extreme quantitative easing by the Fed and the political pressure to continue with this. One might say that Mr Bernanke was nominated because the positive effects on output are visible, while the negative effects on inflation are not.

Second, and perhaps more worrying, is the fact that Mr Obama has the opportunity to appoint almost the entire board of governors at the Fed within his first term. The board consists of seven members or, more precisely, it should consist of seven members. Since April 2006 the Fed has been sailing though the rough waters of the financial and economic crisis with only five governors. Two seats have been empty for years. Former US President George W. Bush tried to fill those vacancies, but the Democrat-controlled Senate has held his nominees at bay.

The consequence is that Mr Obama can nominate two governors to the board instantly, if he so desires. But it does not stop there. The non-renewable term of Donald Kohn, vice-chairman, expires next June, meaning that Mr Obama can soon start looking for his replacement. Another governor appointed by Mr Bush, Elisabeth Duke, will leave the board in 2011 when her term expires. Given that Mr Obama has already made one other appointment to the board, that of Daniel Tarullo in late January, the grand total of Obama nominees would then come to six out of seven governors, Mr Bernanke included. Only one, the 39-year old Kevin Warsh, a former investment banker and former adviser to Mr Bush, has a safe seat. His term does not expire until 2018.

Not only will Mr Obama be able to nominate four governors, a majority, in his first two years, but the Obama-dominated board also has the final say in the appointments of the presidents of the 12 regional Federal Reserve banks. On a rotating basis, five of them have voting rights within the Federal open market committee, the body that decides on the Fed’s open market policy and, thereby, the federal funds rate. Although the regional presidents are appointed by the member banks themselves, their nominations have to be approved by a board of governors that will soon be dominated by Obama appointees.

That is worrying as research shows that when presidential popularity is declining, the incumbent is likely to influence the Fed to stimulate the economy by keeping interest rates low. In terms of popularity, Mr Obama has started from a very high level. Given that the unemployment rate is likely to continue rising even if the US economy recovers earlier than expected, we should expect the independence of the Federal Reserve System to come under further pressure.

Sylvester Eijffinger is professor of financial economics at Tilburg University and was visiting scholar at the Federal Reserve System in Washington. Edin Mujagic is economics editor of the weekly FEM Business & Finance


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