"Monetary developments during the past few decades have, I believe, been determined far more by the institutional structure of the Federal Reserve and external pressures than by the intentions, knowledge, or personal characteristics of the persons who appeared to be in charge."
--Milton Friedman (1985, p. 4)
The Federal Reserve and Its Independence
Since the 2008 financial crisis, the Federal Reserve System has had an increasingly prominent role in the financial markets. Over the past seven years, the Fed has grown significantly both in size and in its influence over the performance of various financial markets. Supporting the banking system during the crisis more than doubled the Fed's balance sheet as it gave liquidity to banks (and nonbanks) and bought their "toxic" mortgage-backed securities. Now, its balance sheet stands at $3.9 trillion (as of June 1, 2015), more than four and a half times larger than in June 2008. The Fed's influence has also grown significantly due to its broader regulatory role in the banking system under the 2010 Dodd-Frank financial reform bill. Bankers, investors, and pundits try to guess what the Fed will do next because billions of dollars are at stake.
Besides being one of the most influential organizations in the United States, the Federal Reserve's institutional and organizational structures give us an interesting case of entangled political economy. The Fed has also engaged in many "unconventional" monetary policies and programs since the financial crisis. Some of these policies and programs are public; others are opaque. Why has the Fed more than quadrupled its balance sheet in less than ten years? What consequences will its unprecedented expansion have? When will it raise interest rates? How will it respond to the next crisis? And most importantly, should we reform the Fed, and if so, what reforms should we make? We can only answer these questions if we understand what incentives the Board of Governors faces and how they differ from the incentives faced by the district banks. Successful reform will require changing the Fed's structure, not just setting new statutory goals.
An important question is whether or not the Federal Reserve operates independently of political considerations. The literature on Fed independence is divided between those who claim that it is indeed independent (Wallace and Warner 1985; Maier 2002; Caporale and Grier 2005; Blinder 2010) and those who claim it is not (Friedman 1985, 2009; Timberlake 1993; Chappell, MacGregor, and Vermilyea 2005; Meltzer 2009; White 2012; Selgin, Lastrapes, and White 2012; Boettke and Smith 2013a, 2013b). The conflicting results of studies about the Fed's independence should not be surprising for two reasons. First, the subject is complex and there are multiple methods of defining independence. Second, although some scholars have addressed the public-private nature of the Federal Reserve System (Rowe 1966; Woolley 1986), most of the independence studies fail to distinguish sufficiently between the Board of Governors, the district banks, and the Federal Open Market Committee (FOMC). This paper contributes to the independence literature by further clarifying the public and private aspects of the system and by introducing new evidence to support that distinction.
But what are people referring to when they talk about "the Fed"? Is it a single unified organization? How does it make decisions and carry them out? People clearly believe the chairman of the Board of Governors wields a lot of power because Janet Yellen's (and formerly Ben Bernanke's) name appears frequently in conversations about the Fed. Their belief is not without justification. Silber (2012) argues that the board chair exercises a great deal of influence over other board members. She not only leads the Board of Governors, she also chairs the FOMC, meaning she sets its agenda. But just how much does the chair influence monetary policy and what are her constraints? When people talk about the Fed, they are usually referring to decisions made by the FOMC about interest rate targets, lending, or bond-buying programs, and they often attribute those decisions to the chairman. A brief synopsis of the Federal Reserve System will answer some of these questions.
There are three major components of the Federal Reserve System. First, there is the Board of Governors, which is a government agency based in Washington, DC. The board is composed of seven governors, including the chairman, and thousands of staff. Second, there are twelve district or regional Federal Reserve banks. These are not branches of the Board of Governors. They are privately owned banks with separate financial statements and separate boards of directors. Third, there is the FOMC, which meets every six weeks to determine monetary and other general policy for the Federal Reserve System.
The FOMC has twelve voting members: the seven governors, the president of the New York Fed, and four other district bank presidents who serve yearly on a rotating basis. This setup gives the board a majority of the vote. It also limits the ability of the district bank presidents to form a coalition. Table 1 and figure 2, for example, show that although there are more monetary hawks among district bank presidents than among the governors, they regularly rotate off of the committee.
With regard to a "hawkish" coalition, the transition from the 2014 FOMC to the 2015 FOMC saw Richmond bank president Jeffrey Lacker join the committee while Richard Fisher, Loretta Mester, and Charles Plosser all left it. Esther George, who would be categorized as a hawk, is also out of the picture due to the rotation of district bank presidents on the FOMC.
Part of what makes the Fed so interesting and convoluted is that the Board of Governors and the district banks are two distinct and different types of organizations. This observation is not unlike Salter's (2013) point that not all nominal gross domestic product (NGDP) targeting is the same. Stable NGDP emerging under a free banking system is different from a formal NGDP policy target. The twelve district banks behave more like private organizations than like government agencies. They are owned by member banks, they innovate and respond to changes in the market, and they compete with other organizations like the Clearing House Interbank Payments System. District banks have different information and pressures than the board. So although it may appear on the surface that the district banks and the board are the same, their underlying institutional structures are different.
In contrast, the board can be characterized as a political organization because of its governance structures and because it operates according to political/bureaucratic principles. Its directives come from political priorities, not feedback from market participants. When I use the term "Fed" throughout the rest of the paper, I am either referring to the entire Federal Reserve System or to the FOMC.
In the following section, I argue that the Board of Governors is a government agency and raise several objections to treating the district banks like private organizations. Section 3 answers those objections and argues that district banks are more like private entities. In section 4, I consider and reject the centralization theory that the Fed is a single unified organization ruled by the board. I conclude in section 5 by considering recent trends in the Federal Reserve System and the implications of those trends for public policy.
The Board of Governors As a Government Organization
Although few economists, if pressed on the issue, would call the Board of Governors a private organization, many argue strongly that it is independent (Wallace and Warner 1985; Maier 2002; Caporale and Grier 2005; Blinder 2010). But independent from what? It is true that Congress has less control over the Federal Reserve than it has over other government agencies. But does that make the Fed an objective agency that is solely, or even primarily, interested in improving the economy? The Fed has many hallmarks of a government agency. It operates in a political environment and faces bureaucratic incentives to expand its authority, staff, and budget. In fact, the board, and really the whole Federal Reserve System, was created to influence monetary policy and the financial system according to the interests of the state (Cargill 2014).
The board qualifies as a government agency for several reasons. It was created and subsequently modified by act of Congress. It also reports directly to Congress twice a year. Although Congress does not direct the Board's activity day to day, Congress has the authority to change both the tools and the policy objectives of the Fed. The board is also a regulatory agency responsible for writing regulations, not simply carrying them out. No one owns...