Many people are surprised to learn that the central bank of the United States, the Federal Reserve, operates for the most part independently of the government. The combined public and private structure of the Federal Reserve (Fed) is highly controversial, especially in the aftermath of the financial crisis of 2007- 2008

The role of the Fed as central bank in the U.S. and its position of influence highlights the question of whether or not central banks should be independent from the political nature of government.

Key Takeaways

  • Central bank independence refers to the question of whether the overseers of monetary policy be completely disconnected from the realm of government.
  • Those favoring independence recognize the influence of politics in promoting monetary policy that can favor re-election in the near-term but cause lasting economic damage down the road.
  • Critics of independence say that the central bank and government must be tightly coordinated in their economic policy and that central banks must have regulatory oversight.

The Fed as Quasi-Governmental

The monetary decisions of the Federal Reserve do not have to be ratified by the President (or anyone else in the Executive Branch). The Fed receives no funding from Congress, and the members of the Board of Governors, who are appointed, serve 14-year terms. These terms do not coincide with presidential terms, creating further independence.

However, the Federal Reserve is subject to oversight by Congress, which aims to ensure it achieves the economic objectives of maximum employment and stable prices. And the Fed Chair must submit a semi-annual report on monetary policy to Congress. 

Why Be Independent?

The primary justification for an independent Federal Reserve is the need to insulate it from short-term political pressures. Without a degree of autonomy, the Fed could be influenced by election-focused politicians into enacting an excessively expansionary monetary policy to lower unemployment in the short-term. This could lead to high inflation and fail to control unemployment over the long-term.

Indeed, proponents of central bank independence argue that political pressure is too great to let it interfere with monetary policy and macroeconomic decision making. In particular, politicians have short-term goals of re-election, which tend to favor inflationary policies that give the illusion of boosting wages and employment, but at the expense of longer-term growth. Furthermore, inflation can undermine the purchasing power of currency and harm creditors and savers.

Advocates of autonomy thus argue that an independent Fed will better address long-term economic objectives. Independence can also make it easier to execute policies that are politically unpopular but serve a greater public interest. Another argument is that the central bank should be filled with economists and other experts, rather than politicians or those under political sway.

Arguments Against Independence

Critics argue that it is unconstitutional for Congress to assign monetary power to an independent quasi-governmental agency. According to the Constitution, Congress has the power to coin money and regulate its value. In 1913, Congress delegated this power to the Fed through the 1913 Federal Reserve Act. However, some argue that such a delegation is fundamentally unconstitutional. Opponents of Fed independence also suggest that it is undemocratic to have an unelected agency, unaccountable to the US public, dictating monetary policy. 

Another argument against independence is that it fosters poor coordination between the fiscal policy put in place by congress (i.e. taxation and spending) and the monetary policy enacted by central banks. For instance, if the government is cutting taxes (loose fiscal policy), but the central bank is raising interest rates (tight monetary policy), creating a mismatch that undermines both's efforts.

The Bottom Line

Fears over the massive expansion of the Federal Reserve balance sheet and questionable bailouts to firms such as American International Group, Inc. (A.I.G.) have led to demands for increased transparency and accountability. Recent calls in Washington to 'audit' the Federal Reserve could potentially undermine the independent status of the US central bank.