To provide for the establishment of Federal reserve banks,
to furnish an elastic currency, to afford means of rediscounting
commercial paper, to establish a more effective supervision of
banking in the United States, and for other purposes.
How Structure Affects the Function of Monetary Policy
Our 200th year, perhaps more than most years, has generated its
share of questions about monetary policy and about the role of
the Federal Reserve System—the nation's central bank—in
solving our economic problems.
Over the past few years, the dual problems of inflation and unemployment
have been especially vexing. And questions about how effectively
our money managers are responding to such problems reflect the urgency
and complexity of the inflation/unemployment dilemma.
These questions also reflect increasing reliance on monetary policy—managing
the supply of money and credit—as a means of assuring national
economic health. That emphasis has grown as we have had to cope
with large deficits and difficult economic events such as the
energy crisis, fluctuating foreign currencies, and continuing
The focus on monetary policy has generated questions not only
about policy actions, but about the structure and power relationships
of the Federal Reserve System—questions about its "independence."
Differences of opinion over monetary policy actions are to be
expected, regardless of how the System is structured. Given the
limits of human wisdom and the incomplete state of our economic
knowledge, such differences are normal and inherent. That there
is such disagreement does not mean the procedures are wrong or the
If, on the other hand, the structural make-up of the System, or
its procedures, tends to inhibit development and implementation
of good policy decisions, then we can try to improve those structures
Since our world is changing and issues seem to be getting more
complex, it would be surprising if some adjustments in the mechanisms
for monetary management might not prove useful. It's against this
background that the various proposals to change the structure and
limit the "independence" of the Federal Reserve System deserve to
The Semantics of Fed Independence
Quite probably the term “independence” has been over-used. It
was a key concept in the design of our central banking system—but
in a relative sense, not as an absolute.
What does “independence” mean? Is the Federal Reserve accountable?
Is it responsive to changing national priorities?
First, let's be clear on what independence does not mean.
It does not mean decisions and actions made without accountability.
By law and by established procedures, the System is clearly accountable
to congress—not only for its monetary policy actions, but
also for its regulatory responsibilities and for services to banks
and to the public.
Nor does independence mean that monetary policy actions should
be free from public discussion and criticism—by members
of congress, by professional economists in and out of government,
by financial, business, and community leaders, and by informed
Nor does it mean that the Fed is independent of the government.
Although closely interfaced with commercial banking, the Fed is
clearly a public institution, functioning within a discipline
of responsibility to the “public-interest.” It has a degree of
independence within the government—which is quite different
from being independent of government.
Thus, the Federal Reserve System is more appropriately thought
of as being “insulated” from, rather than independent of, political—government
and banking—special interest pressures. Through their 14-year
terms and staggered appointments, for example, members of the
Board of Governors are insulated from being dependent on or beholden
to the current administration or party in power. In this and in
other ways, then, the monetary process is insulated—but
not isolated—from these influences.
In a functional sense, the insulated structure enables monetary
policy makers to look beyond short-term pressures and political
expedients whenever the long-term goals of sustainable growth
and stable prices may require “unpopular” policy actions. Monetary
judgments must be able to weigh as objectively as possible the
merit of short-term expedients against long-term consequences—in the on-going public interest.
Monetary decisions have special importance because of their
impact on all other aspects of our economic life. In a very real
way, the power to create money also carries the power to destroy
its value. Pushed to extremes of misjudgment or ill advised action,
misuse of monetary power can erode values and destroy the economic
fabric of the society it serves—by inflation, boom-bust
depression, immoderate stimulus, or by excessive restraint.
... And Its Limits
While monetary policymakers have great potential power over the
economy, there is misunderstanding about the practical limits of
such power. Typically, monetary policy can restrain credit expansion
more effectively than it can stimulate borrowing. It can control
the supply of money, but not the demand for it. It can influence
interest rates, but not control them. The central bank can influence
only a few of several factors that determine the course and vigor
of economic performance. The problems are complex and constantly
changing, our knowledge is never complete, and mechanisms for avoiding
harmful policy side-effects are not adequately developed. Finally,
the ultimate effects of monetary actions are not precisely known
until months later, if at all.
Thus, just as responsible monetary policy must avoid extreme actions—which
on balance may be more harmful then helpful to the economy—so
must the public be restrained in its expectations as to what monetary
policy alone, however well managed, can accomplish.
The Lawmakers' Role
Politicians, the elected representatives who make our laws and
determine public policy, are themselves subject to pressures inherent
in our structure of government. They are expected to respond to
the desires and needs of their constituents. And constituent expectations
tend not to be tempered by such realities as cost and resource limits.
In short, politicians are under pressure to accomplish more than
available resources permit. That can mean attempting more than we
can afford or are willing to pay for. Put another way: it is easier
to vote for needed programs than for increased taxes. Such pressures
probably give our national policies and goals an inflationary tilt.
This is especially true in a democracy where the powers delegated
to our elected officials must be affirmed by “back home” constituents
every two, four or six years. The need for our elected representatives
to be responsive and "tuned in" to their constituents is a vital
function in our political process. It provides important guarantees
to citizens. But it may also limit the extent to which elected representatives
can afford to consider the long-term merits of policies. Policy
actions that may lead to defeat in the next election, however valid,
are not likely to be seen as attractive options.
Balanced policy therefore requires an institutional structure
that insulates monetary policymakers from such short-term pressures—which
is to say, one that also insulates elected officials from the
negative electoral consequences of policy decisions that may be
essential but unpopular.
Obviously, not all policy decisions pose this type of conflict.
Not all elected officials yield to short-run pressures or would
need to. In any case, the merits of a given policy are seldom unambiguous.
But the consequences of persistently expansive monetary policy are
too severe to risk procedures that compound a bias in favor of short-run
options and produce short-sighted results.
Historically, we have used a variety of mechanisms to manage
money—a stock of silver and gold bullion or currency backed
by metals. These mechanisms regulated the money supply according
to irrelevant changes in our stock of metals and offered little
or no consideration of actual needs of the economy, short- or
Our own history, and the experiences of other nations, are replete
with examples of run-away inflation and economic chaos that developed
because the lure of superficial solutions outweighed responsible
but less popular policy actions.
Out of long experience, our monetary system has evolved so that
the supply of money and credit are “managed” at levels intended
to be most conducive to stability, growth, and a high level of production
and employment in our national economy. That responsibility requires
not only a high degree of technical knowledge about the economy
and the interaction of its different elements and forces but also
requires objective, “independent” judgments about the best monetary
adjustments to help achieve those national goals.
History of Reforms
Over the years the Federal Reserve System has proved remarkably
adaptable to changing needs. Both policies and procedures have
been altered when the need for change became clear—sometimes
by statutes or amendment to the Federal Reserve Act, often by
policy and administrative implementation within the authority
of the Act.
The Federal Reserve System was barely in operation when it became
apparent that purchases of government securities, now the main mechanism
for influencing the money supply, added to bank reserves and thus
became an unexpected mechanism for effecting monetary expansion.
The Banking Acts of 1933 and 1935 reaffirmed and strengthened
the Federal Reserve's independence from the executive branch—they
removed the comptroller of the currency and the Secretary of the
Treasury from the Federal Reserve Board—and affirmed its
independent budget and income procedures. They delegated to the
Fed the power to control stock margin requirements and to regulate
savings interest rates.
World War II saw the central bank directly supporting the financing
of unprecedented war expenditures with subsequent monetization of
that debt after the war. In the famous “accord” of 1951, after lengthy
debate both public and within government, it was agreed that the
Federal Reserve would no longer support (by its purchases of government
securities) the artificially low interest rates and par values for
financing government debt. Thus ended the domination of monetary
policy by the Treasury's needs to finance its massive war-born debt.
The Employment Act of 1946 affirmed “maximum employment” as one
of the goals of Federal Reserve policy, establishing formally that
monetary policy has a responsibility to support and help implement
In more recent developments, congress has delegated additional
authority to the Fed under the consumer Protection Act to regulate
“Truth in Lending,” “Equal Credit Opportunity” and other consumer
Over the years, it became clear that monetary policy had to be
uniform throughout the nation, that regional variations were not
possible. Yet the concept of a “federal” system, with input from
various regional perspectives, was important in the policy process.
The establishment of the so-called Federal Open Market Committee
(FOMC), combining the Board of Governors and five Federal Reserve
Bank presidents as the major policymaking body, represented a
major structural innovation that accommodated the needed change.
Independent... From Whom
Representative Carter Glass and his congressional contemporaries
worked out the remarkably durable provisions of the Federal Reserve
Act within the context of our federal system of structural checks
and balances. The terms of the seven Federal Reserve Board members
(14 years—originally Board terms were 10 years, changed
to 12 years in 1933 and to 14 years in 1935) are not so long or
unchangeable as the life-time appointments of justices to the
Supreme Court, but are long enough to make the partisan political
prospects of a next election substantially irrelevant.
Ultimately the System is accountable to congress, not the executive
branch, even though Reserve Board members and the chairman are president-appointed.
The authority and delegated policy powers are subject to review
by the congress not the president, the Treasury Department, nor
by banks or other interests.
Because the Federal Reserve System finances its operations from
internally generated income, it does not depend on congressional
budget appropriations. This is an essential element of “insulation,” since the power to appropriate budgets is the power to control.
This principle was reaffirmed in the Banking Act of 1935 and again
in the Government Corporation Control Act of 1954.
The check and balance structure extends in other ways. Directors
of regional banks are required to represent borrowers and the general
public as well as banks and lenders. The regional structure itself
ensures the representation of varied regional interests in economic
research and policy formulation, as well as directly on the FOMC.
Members of the Board of Governors must themselves be geographically
Finally, an important element of insulation results from the ability
to have policy deliberations conducted in a manner and climate that
ensures maximum candor by all staff and officials involved. Alternative
policies cannot be discussed fully and realistically without such
Pressures for Reform
Pressures for reform of the Federal Reserve System stem from three
kinds of concerns: (a) disagreement with monetary policy, (b)
disagreement with how the System functions in a procedural context,
and (c) disagreement as to its accountability—to Congress,
to the executive branch, to the public.
Disagreements over monetary policy are inherent. Knowledgeable
monetary experts and economic professionals can and often do disagree
over appropriate action, timing, methods of implementation and
degree of emphasis. Typically, there is more disagreement over
the precise degree of restraint or stimulus than over the direction
of policy, whether restraint or stimulus. But disagreement over
policy is normally healthy disagreement. It does not in itself
justify reform unless policies are clearly bad, and clearly bad
for reasons of structural dysfunction.
Critics of monetary policy often cite the need to coordinate monetary
with other national economic policies: the various agencies of
government should not work at “cross-purposes.” Working at cross-
purposes can be wasteful and inefficient. It may be an indication
of bad policy on the part of one agency or on the part of all.
But agreed-upon policy objectives often conflict in implementation—as
when we seek more “good things” than limited resources can provide,
or when lower interest rates also mean more inflation. The populist
goals of readily available credit at low interest on the one hand,
and the dangers of rising prices, inflation and subsequent recession
on the other, are the classic issues of monetary/economic policy
debate, about which there is not only honest argument but also
At times, rapid increases in federal expenditures—and deficits—have
forced over-reliance on monetary restraint to curtail inflation.
In the context of checks and balances, it can be prudent to have
a system where not all agencies or branches of government are
required to arrive at the same judgment concerning the nation's
economic needs and prospects.
Other criticisms stem from the fact that the Federal Reserve System,
as our central bank, is institutionally related to banking—especially
member banks. Member banks elect six of the nine directors of
each regional Federal Reserve Bank. And each member bank owns
nominal stock in its district Federal Reserve Bank. Boards of
regional Federal Reserve Banks have been, de facto, largely representative
of banking, financial and business interests—more or less
by deliberate policy. Understandably, the boards of regional Reserve
Banks must include knowledgeable banking and business leaders,
since one of the regional Bank's major functions is to work jointly
with and through member commercial banks in providing financial
services to business, government, agriculture and the district
economy. In practice, this has meant that they have not been specifically
representative of the interests of consumers, organized labor,
minorities, or women—however those interests may be defined.
But this is in process of change.
Several suggestions for reform of the Federal Reserve System have
been proposed, some of which seem acceptable, even if not offering
substantive improvements. Collectively, they might enhance the public's
understanding of the Federal Reserve as a public institution and
its functioning as the “supreme court” of monetary policy. Among
the recent proposals are:
- The term of the chairman of the Federal Reserve Board should
be coterminous with the president's. Some have suggested that
a six or twelve-month overlap would be wise and in the interest
of stability, allowing a new president to be deliberate in selecting
a new chairman. Others note that the current procedure has not
caused problems and may have merits worth preserving.
- There should be broader representation among district Bank
directors. This proposal seems desirable and in keeping with
a legitimate concern for the interests of consumers and minorities.
- Historically, educators and farmer-ranchers have been well
represented on the Minneapolis Bank's Board of Directors.
Expanding the number of board members—a proposal that
was made last year—would make it possible to add persons
with a broader range of backgrounds and experience without
losing the contributions of present representation.
- The member bank stock arrangement should be eliminated. This
suggestion would seem to have little material effect. It may
now be regarded as an incidental aspect of membership, thought
useful at the time the Federal Reserve Act was enacted. It
is not an essential mechanism for Federal Reserve membership,
but a useful one and certainly not harmful in symbolizing
the stake and the participation that commercial banking has
in the central bank process.
In contrast, the issue of Federal Reserve membership is of
major significance. Both equity and efficiency require that
competing financial institutions be subject to broadly similar
reserve requirements. This issue becomes more important as
other non-bank financial institutions (such as savings and
loans) expand their role.
- There should be fuller discussions on policy deliberations
and more immediate reporting of FOMC policy decisions and plans.
This recommendation has much broader significance. More public
knowledge and discussion of Federal Reserve policy would lead
to a more informed public and more sophisticated understanding
of the issues. Clearly a desirable result. At the same time,
reforms should not destroy the freedom of policy makers to explore
and discuss all policy options without the inhibiting influence
of exposure to public misinterpretation or criticism during
the formulative process.
- There should be full and frequent reporting to Congress of
policy actions and expectations. This proposal would seem to
be helpful to all concerned. The current procedure of regularly
reporting to Congress on the "targets" of monetary growth has
been generally constructive. Time and experience with this procedure
may suggest whether more detailed reporting would be useful.
Insulation ... how it works
Being “independent within” the government means a monetary function
that is insulated from, yet fully aware of, other essential needs
such as national defense, foreign policy and trade, resource development,
housing, and employment. Constructive policy derives from a structure
which can be both coordinative and independent, within government
and also beyond government.
It will be helpful, then, to examine such cooperative/independent
relationships between the Federal Reserve System and the other elements
with which it must coordinate. These include:
- The executive branch, including the president and his advisors,
the Treasury Department and other agencies.
- The Congress.
- Banking and private financial institutions.
- Structural relationships within the Federal Reserve System
With The Executive Branch
Independence from the executive branch of government was a main
concern during the development of the Federal Reserve System, as
it has been since. Yet it is essential that the monetary function
work in cooperation with the president and his economic advisors
and with the major agencies of the executive branch, principally
the Treasury Department.
Given the power and influence of the presidency, that office can
exert strong pressure and influence on any agency. By and large,
presidents have been careful not to abuse this power, respecting
the need for an independent monetary authority.
Following World War II it appears that President Truman did, for
a time, support the Treasury Department in its need to finance the
public debt and approved the then subordinate role of the Federal
Reserve System in supporting that effort. When this impasse was
resolved, the Federal Reserve's responsibility and accountability
for monetary actions were restored. Since then, the “independent” relationship between the two agencies has functioned well.
There are any number of linkages between the Federal Reserve and
the economic agencies of the executive branch. They are formal and
informal and they function at both the policy and staff levels.
The chairman of the Board of Governors, for example, joins the Secretary
of the Treasury, the chairman of the Council of Economic Advisors,
and the director of the Office of Management and Budget in meetings
of the so-called Quadriad. When the Federal Open Market Committee
takes policy actions which it believes to be in the best interest
of the nation, it does so with full knowledge of the administration's
plans and objectives.
... And the Treasury
The central bank is in constant contact with the Treasury Department
which, among other things, is responsible for the management of
the public debt and its various cash accounts.
Prior to the existence of the Federal Reserve System, the Treasury
actually carried out many monetary functions. And even since, the
Treasury has often been deeply involved in monetary functions, especially
during the earlier years.
At the beginning of World War II, it appeared desirable that the
Treasury be able to issue debt at relatively low interest cost and
also on a basis that assured purchasers that securities would be
marketable at near face value. Because of the urgency of this need,
the policy was agreed to and continued after the war until 1951.
During this period, the Treasury was, in effect, deciding the monetary
policy of the country as it made its decisions as to how much debt
needed to be funded. Because the central bank supported the market
for government securities, it was forced to purchase amounts of
securities necessary to maintain low interest rates and the par
value of securities. Thus, as the Treasury issued additional debt,
the central bank was forced to acquire part of that debt. This process
resulted in direct addition to bank reserves.
Following the 1951 accord between the Treasury and the Federal
Reserve System, the central bank was no longer required to support
the securities market at any particular level. In effect, the accord
established that the central bank would act independently and exercise
its own judgment as to the most appropriate monetary policy. But
it would also work closely with the Treasury and would be fully
informed of and sympathetic to the Treasury's needs in managing
and financing the public debt. In fact, in special circumstances
the Federal Reserve would support financing if unusual conditions
in the market caused an issue to be poorly accepted by private investors.
The Treasury and the central bank also work closely in the Treasury's
management of its substantial cash payments and withdrawals of Treasury
Tax and Loan account balances deposited in commercial banks, since
these cash flows affect bank reserves.
With the Congress
A second major relationship, of course, is with the Congress—the
branch of government that specifically delegated, in the form
of the Federal Reserve Act, the responsibility for managing monetary
policy in the interests of the nation. At the same time, Congress
retained responsibility for the taxing and spending decisions
of the federal government.
When the balance between spending and taxation results in government
deficits, the Treasury has to issue additional public debt. In
a monetary sense, the failure to tax adequately to cover the expenditures
of the Federal government is an invitation for “printing money” through the issuance of federal debt. Depending on the phase of
the business cycle, this tends to increase the money supply and,
without offsetting action by the central bank, can result in an
inflationary rise in prices. The result is “hidden taxation”—
which takes away from taxpayers in the form of lower purchasing
power (higher prices) what they would have paid in additional
taxes had the expended funds been obtained through that source.
Thus there is an important linkage between the taxing and spending
powers of Congress and the monetary powers as delegated to the Federal
Reserve System. In principle, it is the job of Congress and the
executive branch jointly to define the economic policy objectives
of our national government, and to support those objectives with
appropriate fiscal measures. Then the central bank can coordinate
monetary policy in a manner which serves those national objectives.
When fiscal policy does not match spending appropriately to tax
revenues, then the monetary authority is faced with a difficult
choice: (a) how severely should it restrain the inflationary forces
that may develop, and (b) to what extent should it permit inflationary
forces to have their effect in higher prices? When the failure
to provide appropriate tax revenues generates acute forces of
inflation, then even the best compromise may require severe monetary
restraint. This has the effect of appearing to be at cross-purposes
with congressional intent and can also produce severe disruptions
in some areas of the private sector such as housing.
Thus, the Congress and the Federal Reserve System may not always
appear to agree in their policy actions, but they have a substantial
common interest in coordinating such policies. Monetary policy can
be less extreme when fiscal policy is doing “its share.”
Another reason for delegating the monetary responsibility to an
authority not directly a part of the government is the high degree
of technical expertise required to analyze economic data, trends,
and other information related to appropriate monetary decisions.
While the Federal Reserve has been called the monetary “agent” of
Congress and is subject to its ultimate control, its special responsibilities
require a separation in carrying out its unique functions. Congress
cannot effectively legislate day-to-day monetary decisions, nor
even provide operating mandates.
In the dialogue between the Congress and the central bank, both
the intent of the national policy and the rationale for appropriate
monetary policy must be communicated. To accomplish this, the Federal
Reserve System reports regularly to the Congress with regard to
its conduct of monetary policy. Over the years, exhaustive hearings
have been held by the Senate and House banking committees regarding
the functions and procedures of the Federal Reserve System. The
Joint Economic Committee and other committees of Congress frequently
call on Federal Reserve representatives to discuss both policy and
A third area of independence relates to commercial banking and
other private financial institutions.
It was no accident that the Federal Reserve System was structured
to include direct representation from commercial banking, for
without a sound banking system monetary policy could not operate.
When the central bank takes action to restrict or expand the money
supply, the multipliers set in motion are leveraged through the
banking system—often to the discomfort of bankers themselves.
When monetary policy is restrictive, the restrictive action takes
place at the loan desks of commercial banks where, with greater
demand for funds and limited money to lend because of the restrictive
policy, bankers are forced to decline some loans that both they
and their customers might otherwise consider prudent. Thus is
expansion of the money supply restrained.
All national banks and many state-chartered banks are members
of the Federal Reserve System. It is essential that the majority
of bank deposits in the country be subject to Federal Reserve requirements
in order that the reserve mechanisms for controlling the money supply
can function well and equitably. In addition, the central bank is
charged to perform other services for member banks such as supplying
coin and currency, clearing checks, transferring funds, and making
loans to member banks under special circumstances. These services
require direct working relationships with commercial banks. The
Federal Reserve's supervisory role (and also the central bank's
ultimate role as the lender of last resort) reflects both the public
need and the monetary need for sound banking.
Through all these close ties and relationships, it is essential
that the central bank deal “at arm's length” with commercial banking
in general and that it not be dominated or made subservient to banking
interests. This also has been a major concern of Congress over the
years and is a concern that is reflected in its design of the Federal
Reserve Act. It is one of the reasons why the Federal Reserve's
bank supervision and regulatory functions are structurally accountable
to the Federal Reserve Board rather than to regional bank boards.
One other area in which separateness and independence have significant
meaning is within the Federal Reserve System itself.
As originally conceived, the regional Federal Reserve Banks were
largely autonomous: a federation of regional institutions made up
the Federal Reserve System. As time and experience brought changes,
it became necessary to coordinate monetary policy on the national
level, while continuing to perform central bank services for member
banks, including the discount (lending) function at the regional
Regional Federal Reserve banks are regularly examined by the Board
of Governors to confirm the internal quality and integrity of each
Bank's operations and also to ensure that regional Banks are complying
with all statutory regulatory requirements of the System.
An important feature within the Federal Reserve is that the chairman
of the Board of Governors, though spokesman for both the seven-man
Board and the Federal Open Market Committee, does not have independent
authority. He cannot establish policy himself nor control policy
decisions. He is subject to and limited by the majority vote of
the councils of which he is part.
Thus, there exists within the System itself checks and balances
which limit the authority and the power of its different elements.
These relationships are significant when structural changes are
Perspectives on Independence
Our central bank structure—functioning in an environment
reasonably insulated from the day-to-day pressures of partisan
politics and short-term expediency—was born out of decades
of experience with boom/bust recessions, financial panics, and
Over the years, the System and its vital monetary function have
been under constant scrutiny and review by Congress, by professional
economists, by banks and financial experts as well as by the public.
Hearings by Senate and House banking committees on Federal Reserve
responsibilities and procedures have been exhaustive.
Such studies have produced innumerable changes in responsibilities,
authority and procedures. It is through such efforts that our
monetary mechanisms have kept pace with the changing needs of
the times. While many problems persist, it is also true that over
the past three decades—and despite some pretty difficult
times—recessions have been moderate, and severe panics and
disruptions have been largely avoided.
Whether the proposals currently suggested are useful remains
to be seen. But the role of the Federal Reserve System in carrying
out the exacting responsibilities of managing the nation's monetary
policy requires the best structural and procedural framework possible
to do that job. The record suggests that a degree of “independence” is essential for effective execution of its monetary role. There
is a recognized need for professionalism in analysis and formulation
of policy —free of partisan/expediency considerations and
free of distraction from other responsibilities.
Urgent and changing economic needs call for frequent review, evaluation,
and suggestions for reform—relying on the tested lessons
of past experience as we learn to understand and cope with new
A System that provides responsible policy must serve the broad
public interest, remaining objective and removed from special interest,
yet ultimately accountable to and in dialogue with the realities
of changing times, human values, and economic conditions.
* Robert W. Worcester, vice president at the Federal Reserve
Bank of Minneapolis, provided valuable assistance in preparing
this text for publication.