Audit the Fed

Audit the Fed

Michael Dotsey FRB of Philadelphia

March 27, 2017

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Overview  Discuss Audit the Fed type legislation  Doing so touches on important issues  Rules vs Discretion  Transparency and accountability  Independence • Is it more essential to constrain the central bank or the government?

• Goal independence vs instrument independence

 The Role of Monitoring  Goal Deviations vs Instrument Deviations

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Overview  Main messages:  FOMC accountability is important  Legislation as written probably do more harm than good  GAO audits can compromise independence  Monetary Policy Report is probably a better way to go

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Legislation  Federal Reserve Transparency Act (S .16 Rand Paul and H.R. 24 Thomas Massie)  Direct GAO to complete an audit of Board and Regional Reserve Banks within 12 months  Allows GAO to audit • International finanancial transactions • Deliberations, decisions, and actions on monetary policy matters • Transactions made under direction of FOMC • Discussions or communications among Federal Reserve officers, board members, and employees regarding any of the above

 This bill appears to have limited support

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Legislation  Fed Oversight Reform and Modernization Act of 2015 (H.R. 3189 Bill Huizenga with 20 Cosponsors)  Requires FOMC to submit a Directive Policy Rule within 48 hrs after each Committee meeting  Includes a Reference Rule (Taylor 1993)  Directive Rule requires explanation and justification if it departs from the Reference Rule  Systematic rule need not be followed if FOMC perceives due to changing market conditions  In that case, within 48 hours FOMC must submit explanation to GAO and congressional committees and GAO determines if FOMC in compliance  Noncompliance may require congressional testimony and a GAO audit

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Legislation  Increases number of Presidents voting from 5 to 6 and removes NY permanent vote  Chair reports to Congress quarterly

 The bill passed the House on Nov 19, 2015

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Audit the Fed  Important Policy Considerations  H.R. 5018: Audits actual funds rate setting rather than evaluating overall performance  Taylor rule may not be close to an optimal rule.  Not very clear on what constitutes noncompliance.  Could politicize monetary policy – what are the consequences? Potentially places a lot of monetary policy deliberation in the hands of the GAO and Congress

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Plan  Plan  Review briefly rules vs discretion  Discuss the economics of monitoring  Look at a reference rule  Conclude, this is a bad idea. Better to have a Monetary Policy Report

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Central Bank Independence  Rules v Discretion  Consensus that rule like behavior dominates purely discretionary behavior  However, we don’t know enough to posit the single best rule  But rules can act as benchmarks, helping to establish systematic behavior, transparency, and enhance credibility  But systematic transparent behavior makes policy better understood by the public yielding better economic outcomes

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Monitoring an Agency  Why monitor goals?  Can reduce political pressure when goals are clearly articulated – inflation target.  Can help add substance to the goals making it less likely that they will be abandoned or adjusted frequently.  Goal-based regimes are likely to be more robust to structural changes than instrument-based regimes

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Monitoring  Why monitor actions?  Can help achieve commitment and reduce inefficient stabilization due to time inconsistency– adhere to rules.  Can help make policy more robust.  Insures accountability  The desire to limit discretionary behavior of the central bank must be balanced against the banks ability to perform stabilization policies  But determining the correct rule is difficult, model specific, and would not give guidance for things like balance sheet policies

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Monitoring  But for monitoring actions to be helpful requires higher hurdle.  Carl Walsh shows that if the Congress knew the exact model and the rule was based on the model’s theoretical output gap, then monitoring the funds rate would improve policy.  But requires use of model based output gap • If you use a statistical output gap, that monitoring inserts mistakes that are costly. “When the rule takes the form proposed in the recent Congressional hearings, it is never optimal to use the rule to assess the central bank’s performance. In fact Walsh(2015) shows it is quite harmful  Robustness issues – which model?

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Monitoring  Will Conditions for helpful monitoring of instrument be met?  No  No idea of optimal rule and it may be complex  No idea of the correct model  Rule may need to be contingent on ZLB  Taylor 1993 is not useful reference rule (not designed for this role)  Forward guidance at the ZLB would argue for departure from most rules used in normal times • Strict adherence at ZLB might lead central bank to raise its inflation target so as to not be punished for rule departures FEDERAL RESERVE BANK OF PHILADELPHIA

Monitoring  Robustness  Ilbas and coauthors take this up and look at how some simple rules work in very different models of the economy  While not the best rule in any model, some work reasonably well in all models  Simple rules may then be useful as guidelines, but should not be mechanistically adhered to

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General Form of Optimal Rules  Rules  Gianonni and Woodford explore this issue in a couple of papers  Basic properties include inertia and a rich lag structure  Taylor 1993 has none of those properties

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Results  According to the outcome based the Fed has behaved fairly systematically.  Until 2014 it is rare to find any deviations greater than 20 bp. Currently (2016Q4) it appears that the funds rate is about 70 bp below what would be indicated by the Directive Rule  The earliest big discrepancy is when the FOMC started aggressively cutting rates in late 2007 one quarter ahead of the timing suggested by the rule  We also see that liftoff should have occurred in 2014Q2, and that the Q4 funds rate would be a touch above 1 percent  Not so the Taylor Rule  Many large discrepancies inviting all kinds of congressional oversight FEDERAL RESERVE BANK OF PHILADELPHIA

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Results  The FOMC may have learned something between 2001 and 2008 or different principles may have had different economic views  So estimate the rule through 2008 and repeat the exercise  There are minor differences with policy as of 2014Q4 only 45 bp below that indicated by the rule

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Results  FOMC is behaving a bit cautiously relative to the rule, but there are good theoretical reasons to deviate to the downside due to ZLB constraint that policy faced for a number of years  There are reasons that justify the departure as well  Asymmetric risk at ZLB  At ZLB may want to rates lower for longer (Woodford)  Long bout of inflation below target (potential to unanchor inflation expectations)

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Audit the Fed  Audit the Fed will merely politicize monetary policy and may do more harm than good  Generally countries with politicized monetary policy don’t achieve good results  Congressional involvement at detail of H.R. 3189 probably not a good idea  Oversight would more profitably revolve around goals and regular reports to Congress  We already have this

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Audit the Fed  Monetary Policy Reports  The Ilbas et al. analysis indicates the simple rules can productively be used for benchmarking  Examples abound in the Monetary Policy Reports of various Central Banks  Make policy more transparent  Helps align the public’s expectations with those of the policymaker  Fed behaves systematically and does communicate actively. But there may be room for improvement

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