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I generally support central bank “independence,” but this independence comes at the price of constraints and accountability. Thus, when a central bank Federal Reserve doesn’t manage to achieve its goals, or makes particularly aggressive and innovative use of its powers that end up with high costs, then then Fed needs to be accountable for those choices. Andrew T. Levin and Christina Parajon Skinner consider some Fed decisions in recent years in “Central Bank Undersight: Assessing the Fed’s Accountability to Congress” (Vanderbilt Law Review, 2024, 77:6, pp. 1769-1830). The authors write:

Over the past 15 years, however, the scope and complexity of monetary policy has outpaced Congress’s ability to monitor these policies through existing mechanisms of oversight. For example, internal shifts in the Fed’s governance and power dynamics have led to the disappearance of dissents on monetary policy decisions, thereby hampering legislators’ abilities to discern the range of views that have informed those decisions. Moreover, in conducting its latest round of securities purchases (“QE4”) during 2020–22, the Fed did not provide legislators with cost-benefit analyses or risk assessments at any stage of the program. Indeed, QE4 is now likely to cost taxpayers more than $1 trillion, but its efficacy has still not been scrutinized by any external reviews.

During the pandemic, inflation as measured by the Consumer Price Index spiked up to 9.1% in June 2022. Readers will remember that there was a dispute over whether the underlying cause was supply chain disruptions during the pandemic, implying that the inflation would fade on its own, or driven by high levels of government spending during the pandemic, in which case the inflation might not fade. As usual, the like answer was “some of both,” but the fact remains that inflation started rising early in 2021 and the Fed did not raise interest rates to counteract that inflation until
spring 2022, at which time inflation started falling soon thereafter. It felt to me as if the Fed was reluctant to raise interest rates for a time because it might seem to be criticizing or blaming the spending bills from the incoming Biden administration for the rising inflation, instead of just reacting to the fact of higher inflation as it got started.

Levin and Skinner focus on a broader but related issue: the shift in how the Federal Reserve operates and conducts monetary policy. Pre-2008, the Fed generated income from providing services to banks (like check clearing) and by holding Treasury bonds that paid interest. Banks held minimal reserves at the Fed, and the Fed didn’t pay any interest on these reserves. The risks involved, along with the Fed’s expenses, were both low. In a given year, the Fed generated a surplus measured in tens of billions of dollars, which was then paid to the Treasury.

This model of how the Federal Reserve operates has been tranformed. The authors write:

[T]he size and composition of the Fed’s balance sheet has changed dramatically since 2007. At that time, paper currency accounted for 95% of the Fed’s liabilities, which stood at about $800 billion. Since then, the Fed’s balance sheet has expanded by a factor of ten to around $8 trillion as of 2023, and interest-bearing bank reserves and reverse repos now comprise nearly two-thirds of the Fed’s total liabilities. Moreover, since fall 2022, the Fed has been incurring net operating losses and funding that cost by expanding its interest-bearing liabilities, in effect borrowing those funds directly from the public without congressional authorization. Indeed, the Fed’s programs and operations are exempted from the appropriations process, the debt ceiling, and standard accounting rules.

 

I have tried over the years of writing these posts to explain changes like why bank reserves went way up, the Federal Reserve now paying interest on those reserves, quantitative easing policies, the Fed’s use of the reverse repurchase market, and other issues. Here, I won’t try to explain all these terms. My first point is just that the fundamental structure of the Federal Reserve balance sheet, as well as how it conducts monetary policy, have shifted dramatically.

As one result from these changes, Levin and Skinner offer a striking figure showing that from 1960 up to about 2020, the Fed has a surplus each year–sometimes higher or lower, but typically in the range of 0.2-0.5% of GDP, which it paid to the US Treasury. One result for this shift was that, both during the pandemic and before, the Federal Reserve policies of “quantitative easing” ended up with the Fed holding several trillion dollars in federal debt, which had been issued at low interest rates. When the Fed raised interest rates starting in 2022, the interest paid by the Fed on bank reserves necessarily went up, while the funds received from all that earlier low-interest Treasury debt did not. Instead of the Fed being a low-risk operation that paid a surplus to the US Treasury, the Fed actually lost money–which it plans to pay back out of surpluses to be generated in the future.

With all the changes to the financial structure of the Fed, it has been making losses rather than surpluses , and the surpluses aren’t expected to resume for a few more years. The authors estimate that there will be a $1.6 trillion total gap over the 15 years or so between what the Fed would have paid the Treasury under previous arrangements, and what it will end up paying now.
 

I’m aware of the reasons for the changes in how the Federal Reserve operates: indeed, many of the changes seem reasonable to me. Again, I’m a believer that the Fed should have considerable independence, but within constraints of rules and accountability. There was little public or Congressional debate on whether the Fed should expand its balance sheet ten-fold from 2007 to 2023. The power of the Fed to pay interest on bank reserves, for example, was passed by legislation back in 2006 and 2008–at a time when the bank reserves were still quite small. Many of the other changes mostly just happened in response to events like the Great Recession of 2007-09 and the pandemic recession.

I confess that I have little confidence in the ability of Congress to have a reasonable discussion/debate on this transformation of the Fed, and no confidence at all in the ability of the Trump administration to do so. But we have a situation where the Fed was slow to respond to a surge in inflation in 2021-2022, and a situation where the result of accumulated Fed decisions is that the US Treasury will be $1 trillion or more short of funds during the next 15 years that it might reasonably have expected. The Federal Reserve, like most institutions, spends more time explaining how all past choices were necessary, and how all existing problem can work themselves out, rather than examining whether some previous choices were misguided. If the Fed wants to keep its independence (and I want the Fed to have independence), it doesn’t need to be infallible, but it does need to show itself to be publicly accountable.

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