Should We “Audit the Fed”?

April 19, 2017
During his recent presidential campaign, Donald Trump showed support for what he calls “auditing the fed,” which shined a new spotlight on a contentious bill proposed in 2015 by Senator Rand Paul known as “Audit the Fed.” Now, with Trump in the White House and Republicans in control of the House and Senate, the bill and the question of the Fed’s independence have returned to the forefront of national discussion. Here we investigate the arguments supporting the Audit the Fed bill, the current state of the Fed’s independence, how the bill could affect that independence, and the resulting economic consequences.

The Federal Reserve Transparency Act of 2015, or Audit the Fed as it’s commonly known, proposes that the US government should “require a full audit of the Board of Governors of the Federal Reserve System and the Federal reserve banks by the Comptroller General of the United States, and for other purposes.”[1] At first glance, this bill seems reasonable, because its main effect appears to be increasing the transparency of the Federal Reserve. Proponents of the bill contend that it will “force the Federal Reserve to operate by the same standards of transparency and accountability to the taxpayers that [are demanded] of all government agencies.” But a cursory reading overlooks that independent organizations and the government already audit the Fed, and that the bill proposes government involvement in the Fed’s decision-making, not traditional auditing.

Existing Oversight

Accounting firms such as Deloitte and Touche annually perform a complete audit of the financial statements of the Federal Reserve. [2] Furthermore, they release these results to Congress and the public. Beyond this, the Government Accountability Office “conducts numerous reviews of Federal Reserve activities…[with] more than 125 audits…conducted since the financial crisis.” [3] The espoused purpose of the bill—to have congressional oversight and rigorous inspection of the Fed—has already been achieved by extant policy. The rigor of the current supervision calls into question the necessity of additional audits. Rather than innocuously increasing transparency, the additional oversight could fundamentally undermine the Fed’s independence.

Consequences for Federal Reserve Independence

To enhance the Fed’s accountability to Congress, The Federal Reserve Transparency Act of 2015 proposes that “the [audit] report…shall include recommendations for legislative or administrative action as the Comptroller General may determine to be appropriate.” [4] This opportunity for legislative action against the Fed may expose sensitive monetary policy to harmful political pressure. If, for example, the majority party were to disagree with some contractionary measures that economists deemed necessary, members of the House and Senate could introduce legislation to force the Fed to enact expansionary policies instead, effectively stifling the independence of the Federal Reserve system. Though this more active oversight may improve the political accountability and transparency of monetary policy, placing monetary policy in Congressional hands increases the likelihood that politics, rather than the objective needs of the economy, will motivate monetary decisions.

Economic Consequences

The threat posed to the Federal Reserve’s independence by Paul’s bill should be alarming because it may have far reaching economic consequences, especially for inflation. Among the first papers to investigate the empirical relationship between Central Bank independence and inflationary trends was the 1993 paper by Alberto Alesina and Lawrence H. Summers, Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence. [5] In their paper, Alesina and Summers developed quantitative measurements of Central Bank Independence (CBI) to explore the relationship between monetary policy and economic growth.

Like earlier researchers, Alesina and Summers constructed a quantitative approximation of CBI from the legal precedents concerning the founding of the Central Banks in their data set. Legal information incorporated into the measurement of CBI included the lengths of terms of Bank board members, appointment protocol for the board members and board chair, as well as the stated mission of the Bank. Characteristics associated with independence, such as long terms and mission statements including an explicit reference to maintaining price stability—rather than promoting economic growth— produced high CBI index values.

Alesina and Summers concluded that “monetary discipline associated with central bank independence reduces the level and variability of inflation. The researchers posited that non-independent central banks produced higher level of inflation because politicians exploited these banks to garner support among constituents by pressuring them to perform expansionary monetary policy. Though expansionary policy encourages economic growth, ill-timed expansionary policy can cause excessive inflation and trigger price wage spirals.

<p><strong>Image: </strong>A 2009 annual report published by the Federal Reserve Bank of St. Louis includes a graph demonstrating an inverse correlation between CBI and average Inflation—resounding the claims set forth by Alesina and Summers. <strong>Source:</strong> <a href="https://www.stlouisfed.org/annual-report/2009/central-bank-independence-and-inflation">St. Louis Federal Reserve</a></p>

Image: A 2009 annual report published by the Federal Reserve Bank of St. Louis includes a graph demonstrating an inverse correlation between CBI and average Inflation—resounding the claims set forth by Alesina and Summers. Source: St. Louis Federal Reserve


Despite these compelling conclusions, other researchers expressed concern over Summers’ and Alesina’s measure of CBI because they felt it placed undue weight on the legal contexts in which banks were founded. In practice, many governments operate beyond, or around the boundaries of stated laws. To account for this, Debelle and Fischer (1994) argued that CBI should include measurements of so-called “Goal” and “Instrument” independence, which detect a Central Bank’s “freedom to determine the ultimate objectives of monetary policy” and the “means by which it seeks to achieve those goals.” One of the major conclusions from Debelle and Fischer’s study was that in industrialized economies, political independence as defined by characteristics of the Central Bank’s founding, did not generate the negative correlation between independence and average inflation. They found that “Statutory” CBI, better captured the relationship between independence and inflation. Broadly, Statutory Central Bank Independence (SCBI) functions as a measurement of the degree to which government officials, through executive and legislative powers, can influence monetary policy making more directly and immediately than through founding mechanisms.

Debelle’s and Fischer’s findings suggest the ways in which political representatives and institutions influence Central Bank operations directly–for example, by overturning or altering Central Bank decisions–substantially affects economic performance. Their hypotheses were tested in the 1995 publication of Loungani and Sheets which catalogued the relationship between inflation and Statutory Central Bank Independence for former Soviet economies emerging into the free market. [6] This conclusion indicates the Federal Reserve Transparency Act has potential to harm economic stability and increase inflation dangerously because it gives Congress a prominent role in the deliberations of the Fed, which results in a decrease in Statutory CBI.

 <p><strong>Image: </strong>Loungani and Sheets found a strong negative correlation (R<sup>2</sup> = 0.692) between Statutory Central Bank Independence and Inflation Rate among former communist countries emerging into the free market. <strong>Source:</strong> <a href="http://econpapers.repec.org/paper/fipfedfap/94-05.htm">Econ Papers</a></p>

Image: Loungani and Sheets found a strong negative correlation (R2 = 0.692) between Statutory Central Bank Independence and Inflation Rate among former communist countries emerging into the free market. Source: Econ Papers

Several years after Loungani and Sheets published their paper, the Economist declared “price stability has arrived in Central and Eastern Europe,” with a nod toward the inflation trends of Hungary, Poland and the Czech Republic, three countries which were found to have particularly low Statutory CBI. [7]

<p><strong>Image: </strong>Graph of year-on-year consumer price inflation for Hungary, Poland, and the Czech Republic. <strong>Source: </strong><a href="http://www.economist.com/node/1552616">The Economist</a></p>

Image: Graph of year-on-year consumer price inflation for Hungary, Poland, and the Czech Republic. Source: The Economist

To investigate whether the trend of decreasing inflation in countries with high SCBI has persisted over time, we pooled data on the inflation rates of Hungary, Poland and the Czech Republic between the years 2000 and 2015. For comparison, we added two countries which were found in the paper to have very low levels of Statutory CBI: Kazakhstan and Russia. We also recreated Loungani and Sheets’ study mapping the relationship between inflation rates and SCBI, using average inflation rates from 2011-2015 for all countries in the original paper.

<p><strong>Image: </strong>Year-on-year inflation rates for Post-Soviet states 2011 - 2015. <strong>Source: </strong>Original analysis. Data sourced from <a href="http://www.focus-economics.com">Focus Economics</a></p>

Image: Year-on-year inflation rates for Post-Soviet states 2011 - 2015. Source: Original analysis. Data sourced from Focus Economics

<p><strong>Image: </strong>Average inflation rate (2011 - 2015) plotted against statutory central bank independence ranking for Post-Soviet States. <strong>Source: </strong>Original analysis. Data sourced from <a href="http://www.focus-economics.com">Focus Economics</a></p>

Image: Average inflation rate (2011 - 2015) plotted against statutory central bank independence ranking for Post-Soviet States. Source: Original analysis. Data sourced from Focus Economics


<p><strong>Image: </strong>Average inflation rate (2011 - 2015) plotted against statutory central bank independence ranking for Post-Soviet States with Lithuania excluded. <strong>Source: </strong>Original analysis. Data sourced from <a href="http://www.focus-economics.com">Focus Economics</a></p>

Image: Average inflation rate (2011 - 2015) plotted against statutory central bank independence ranking for Post-Soviet States with Lithuania excluded. Source: Original analysis. Data sourced from Focus Economics

Our findings parallel the findings in the literature on the subject. Due to their low inflation rates the high SCBI countries Poland, Hungary and the Czech Republic have relatively stable price levels while Kazakhstan and Russia, the low SCBI countries, had far higher and more volatile rates of inflation. When comparing SCBI ranking to the average inflation rate, we found a negative correlation between the two variables, meaning that countries with less independent Central Banks were found to have higher average inflation rates and visa-versa. One notable fact is that the first graph with Lithuania included has an R2 value of 0.3741 suggesting that the linear trend line shown represents only a modest fit to the data, however the second graph without Lithuania has a rather high R2 value of 0.6799. Lithuania was the only country which did not fit the pattern of low Central Bank Independence coupled with high interest rates. One possible explanation for this is that Lithuania is the only one of the five countries with low levels of SCBI (Lithuania, Russia, Kazakhstan, Ukraine, and Armenia) which joined the European Union in 2004. [8] [9] In joining the EU Lithuania was forced to adhere to Central Banking policies of the Union thus undergoing a significant increase in the level of independence afforded to its monetary policy makers. This positive shock to SCBI could account for the change in inflation trends in the country.

Today, countries with high SCBI like Poland, the Czech Republic, Romania and Bulgaria, are among the only economies in Eastern Europe expected to continue growing at a rate equal to or greater than the average rate of growth for European Union (1.8%). This projected growth could represent evidence that Statutory Central Bank Independence is a good indicator of long run trends in macroeconomic growth and price stability; however, confounding variables make definitive conclusions impossible.

The “Audit the Fed” bill poses a non-trivial threat to US economic growth and stability in light of Loungani and Sheets conclusions that “increased central bank independence tends to improve inflation performance and “high inflation adversely affects real activity in subsequent years.” Independent accounting firms and government agencies currently audit the fed rigorously. Senator Paul’s bill does not enhance this oversight meaningfully. Instead, the bill enables Congress to intervene with monetary policy and overrule the Fed’s decisions. This intervention would significantly reduce the Fed’s statutory independence. A well-developed literature of economic research suggests this reduction could lead to excessive inflation overtime and hinder long-run economic growth. Therefore, the Audit the Fed bill should be abandoned. Monetary policy should remain well-insulated from voters and their representatives.

References

  [1] http://thehill.com/policy/finance/312662-audit-the-fed-bill-gets-new-push
  [2] https://www.federalreserve.gov/faqs/about_12784.htm
  [3] https://www.federalreserve.gov/faqs/about_12784.htm
  [4] https://www.congress.gov/114/bills/hr24/BILLS-114hr24rh.pdf
  [5] http://www.people.fas.harvard.edu/~iversen/PDFfiles/AlesinaSummers1993.pdf
  [6] http://econpapers.repec.org/paper/fipfedfap/94-05.htm
  [7] http://www.economist.com/node/1552616
  [8] http://www.imf.org/external/pubs/cat/longres.aspx?sk=18176.0
  [9] https://europa.eu/european-union/about-eu/countries_en#tab-0-1

 

 

PENN WHARTON PPI
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