

EPA/MATTHEW CAVANAUGH

How independent should the Federal Reserve be?

The general consensus in the wake of the Great Recession has been that the nation’s central bank should operate in a politically sterile environment, pulling whatever levers are necessary to ensure the economy gets back on track -- whether that means slashing interest rates to zero or pumping $4 trillion into the recovery. A recent push by conservative Republicans to increase oversight of the Fed has only deepened the central bank’s commitment to autonomy.

That’s why a new Brookings paper released today is so provocative. It calls for greater cooperation between the Treasury Department and the Fed, particularly during the type of unusual economic and monetary circumstances of the past six years. Lead author Robin Greenwood of Harvard Business School, along with his university colleagues Samuel Hanson, Joshua Rudolph and Lawrence Summers, argue that the lack of coordination has actually diluted progress toward their goals for both institutions.

The paper uses quantitative easing as a case study. Since 2007, the Fed has quintupled its balance sheet to more than $4 trillion by buying up long-term securities. The idea was that soaking up lots of long-term debt would help push down a broad spectrum of interest rates -- and it worked. The authors estimate the Fed’s bond-buying program reduced the yield on 10-year Treasury bonds by 1.37 percentage points.

Now, for the but: At the same time that the Fed was trying to stimulate the economy by loading up on long-term bonds, Treasury was increasing its issuance of long-term debt in the midst of a bleak budget outlook. According to the authors’ calculations, the volume of government debt that matures in five years or longer and is held by the public -- aka not by the central bank -- has nearly doubled from 8 percent of gross domestic product to 15 percent of GDP.

The paper calls the result “reverse quantitative easing.” The authors estimate it has increased 10-year Treasury yields by nearly half a percentage point. The Fed and the Treasury haven’t just been working independently, the paper argues. They have been actively working against each other.



Source: Hutchins Center on Fiscal and Monetary Policy at the Brookings Institution

The authors catalog moments when the Fed and the Treasury have coordinated on policy to establish its historical precedent, such as after World War II when the central bank agreed to keep a broad range of interest rates fixed at a low level. (Those episodes, however, are more often cited as reasons for greater central bank independence, not less.) Perhaps more relevant is the original Operation Twist in 1961, in which the Fed agreed to buy more long-term debt at the same time that Treasury issued more short-term securities.

The authors argue that quantitative easing has already blurred the lines between fiscal and monetary policy: “By shortening the maturity structure of debt instruments that private investors have to hold, the Fed has effectively entered the domain of debt management policy.”

They conclude by calling for the central bank and the Treasury to acknowledge what is already occurring in practice. In theory, that would mean agreeing to managing the debt in a way that promotes America's "national interest." The paper takes a stab at definition that includes the lowest cost of financing government debt, managing fiscal risk, supporting growth and ensuring financial stability and suggests the two institutions divide up those goals. The most concrete proposal in the paper is an annual joint Fed/Treasury statement laying out a strategy for managing the government’s debt -- assuming, of course, they can agree on what exactly it is.

Can the nation's central bank and its accounting office get along without becoming too cozy? Responding to the paper, prepared for the Hutchins Center on Fiscal & Monetary Policy at Brookings, will be Fed Gov. Jerome Powell and Mary John Miller, a former top Treasury official. We’ll let you know whether they shake hands.