We've started to hear a lot about Federal Reserve independence and threats thereto. Bill Dunkelberg, chief economist for the National Federation of Independent Business, recently suggested that members to contact their Senators, urging them to reject proposals that would increase political influence on the Federal Reserve and potentially derail the Federal Open Market Committee (FOMC) from its primary missions of ensuring a stable economy with low inflation and a sound dollar. Is this concern real or simply part of the current partisan debate that has afflicted financial reform efforts in Washington?

We think the concern is real and has just become an even greater concern, given two developments this week. The first was the announced resignation of Vice-Chairman Donald Kohn, and the second is the growing consensus among Senators involved in the financial reform negotiations to create a separate consumer-protection agency with a separate budget within the Board of Governors of the Federal Reserve System. Why have these developments heightened the threat to Federal Reserve independence?

Kohn's resignation creates the third current vacancy on the Federal Reserve Board, which will give the administration the ability to pick or reappoint six of the seven members of the Board. It has already appointed Governors Duke and Tarullo, neither of whom have experience in monetary policy, and the President reappointed Chairman Bernanke to a second term as Chairman of the Board of Governors. With Kohn’s departure, Chairman Bernanke is the Board’s only economist. While this might be fine with some, the fact is that such experience and background is critical to policy formation.

This clustering of appointments is not supposed to happen, given the legal structure of the Board, and it gives the current administration the chance to pack the Board with appointees with similar political and economic preferences and leanings. The economic perspective is especially critical, given the Federal Reserve's so-called dual mandate of low inflation and full employment and the potential tradeoffs between the two, which can critically affect policy and its timing. Our concern here is not whether the present administration is Democrat or Republican, but rather is simply the ability to pick so many governors at one time. This ability is contrary to the intent of how the Board of Governors was structured. Specifically, each of the seven governors is appointed to a non-overlapping fourteen-year term, with a term expiring every two years. Theoretically, this would give an administration the ability to fill at most two vacancies within a President's four-year term. But of course, Presidents have had the opportunity to make more appointments than that, because governors have typically left long before their terms expired, but the current situation is an extreme. Most governors who have left recently had served substantially less than half their allotted terms (of course, some have filled unexpired terms). There are many reasons for early departures, one of the biggest being the low salary and high cost of living in Washington.

The concentration of appointments in time, combined with the desire to subject the appointment of Federal Reserve Bank presidents to more political scrutiny by Washington, represents a dual threat to the maintenance of a truly independent central bank. Unlike the European Central Bank, the Fed's independence is one of tradition and is rooted in performance rather than formalized in law or a treaty.

The second development that represents a threat to independence is the growing consensus among Senators involved in the financial reform negotiations for the creation of a separate consumer regulatory body with a separate budget within the Federal Reserve. The Fed, of course, has been arguing strenuously for some while to keep this authority, and bankers have argued against a separate agency as well. Both groups' positions are rooted in perceptions of self-interest rather than substance. The Fed in true bureaucratic fashion doesn't like to give up authority. But few can argue that consumer protection has been a high priority within the system. The Fed’s most recent flurry of consumer-protection and education activities has arguably been motivated more by embarrassment and turf protection than a proactive intention to improve the decision making of consumers. Believe me; they didn’t just “see the light.” Bankers argue that a separate agency would impose costly burdens on them, which suggests that their position favoring the status quo is rooted in self-interest and the perception that they will be treated in a more accommodative way by the Fed. This claim has some validity, especially when one looks at the thousands of pages of rules and interpretations of Truth-in-Lending, which are mainly oriented towards providing safe harbors for institutions rather than providing protections for consumers. Another poster child is the home mortgage disclosures. The mice-track type in closing documents is useless to consumers in making a decision at the time of closing when it comes to the decision of whether they want to go through with a transaction or not.

There are other reasons to be concerned about lodging consumer protection within a separately established group. First, it isn't clear what role the Board of Governors would or should play in the operations and governance of this new “independent” division. Moreover, it isn't clear how goal conflicts would be resolved. Will the Board have final say? If so, then there really will be no change from the current situation. Meanwhile, this function, if truly separate, will create potential political problems for the Fed should the new body promulgate rules or regulations that conflict with the Fed's safety and soundness responsibilities or its monetary policy objectives. How will these conflicts be resolved, and who determines those tradeoffs? Finally, accountability will still lie with the Board, regardless of how this new division is structured or organized.

However, if consumer regulation were in a separate agency, it would not divert the Fed's attention from its primary mission of monetary policy and financial stability nor could it be used as a political weapon to harass the Board, as it was during the current crisis. Should costly regulations be promulgated that impose undue and costly burdens on financial institutions or that conflict with stability or safety and soundness, then the tradeoffs can be resolved, and will be resolved, in the more open and transparent political arena, where the true costs and benefits can be assessed. Both bankers and consumers would have open access to the political process when it comes to consumer protections rules and regulations.