Why we Need an "Accord" for Federal Reserve Credit Policy: A Note

Abstract

The 1951 Accord between the Treasury and the Federal Reserve was one of the most dramatic events in U.S. financial history. The agreement liberated monetary policy from the commitment, dating from World War II, to support government bond prices. It reasserted the principle of Federal Reserve independence so that monetary policy might serve primarily as an instrument for macroeconomic stabilization. The Federal Reserve, however, executes both monetary and credit policies, and no Accord has yet been established for its credit policies. The reason is that, until recently, fiscal concerns have not threatened the misuse of Fed credit policies in the way that bond price supports did for monetary policy. Large federal budget deficits, a deposit insurance crisis, or significant foreign exchange market intervention could change that.1 Just as the 1951 Accord greatly improved monetary policy, an Accord for Fed credit policy established today, while fiscal concerns are still relatively small, could yield significant benefits in the future. 1. MONETARY VERSUS CREDIT POLICY Distinguishing between monetary and credit policy is straightforward.2 Monetary policy refers to changes in the stock of high-powered money, that is, currency plus bank reserves, accomplished by open market operations in domestic securities or foreign exchange. For example, a central bank takes a monetary policy action if it increases bank reserves by purchasing securities. Credit policy, on the other hand, changes a central bank's assets while holding the stock of high-powered money fixed. For example, a central bank takes a credit policy action when it uses funds obtained by selling Treasury securities to acquire other assets. Credit policies also include regulation and supervision of the banking system, but such aspects of policy will not be discussed here. 2. THE ACCORD PRINCIPLES FOR CREDIT POLICY The 1951 Accord established the principle that monetary policy should be used to stabilize the macroeconomy, regardless of the fiscal concerns of the Treasury. It restored the idea that a fully independent central bank contributes importantly to economic stability.3 Independence insulates the Fed from shortrun inflationary pressures to stimulate employment and help finance the Treasury. It also frees the Fed from having to get Congressional or Treasury approval for its policy actions, enabling the Fed to react quickly to short-run macroeconomic or liquidity shocks. Congress bestows such independence only because it is necessary for the central bank to do its job effectively. Hence, the presumption ought to be that the Fed should perform only those functions that must be carried out by an independent central bank. Monetary policy is both necessary and sufficient to pursue macroeconomic stabilization policy and to deter system-wide liquidity crises. Credit policy directs funds promptly to illiquid institutions when macroeconomic conditions do not call for a change in high-powered money. This suggests the following Accord principles for Fed credit policy: (1) liquidity assistance should not fund insolvent institutions; (2) credit policy should not fund expenditures that ought to get explicit Congressional authorization; (3) Congress should not direct the Fed to transfer assets to the Treasury in order to reduce the Federal deficit. Three Fed credit policies discussed below illustrate the above concerns. First, liquidity assistance potentially provides funds to insolvent institutions and raises the cost of deposit insurance. Second, Fed credit policy may inappropriately finance sterilized foreign exchange market intervention and some foreign expenditures of the Treasury. Third, the transfer of Fed surplus assets to the Treasury, as directed by Congress, potentially weakens Fed independence. In each case, an Accord for Fed credit policy would help implement the above principles. 3. LIQUIDITY ASSISTANCE As a rule, the Fed finances liquidity assistance to depository institutions with funds acquired by selling Treasury securities-leaving high-powered money unchanged. …