Has the fiscal crisis jeopardized the fed's independence? Damned if you do, damned if you don't.

• Author: Makin, John H.

Judging from the response to the Fed's three-year battle against systemic financial collapse and the risk of deflation, it is difficult to escape the conclusion that financial crises and their aftermaths can pose greater challenges to central bank independence than the more traditional pain associated with combating inflation.

Prior to the financial crisis that began to unfold in 2007, it was received wisdom that central bank independence should largely be viewed in terms of the need to insulate the central bank from the political process that would tolerate higher-than-optimal inflation. Writing on central bank independence in 1993, Alberto Alesina and Lawrence Summers drew on the experience and literature tied to the inflationary 1970s and the epic Volcker win over inflation in the early 1980s to suggest that "delegating monetary policy to an agent whose preferences are more inflation-adverse than are society's preferences serves as a commitment device that permits sustaining a lower rate of inflation than would otherwise be possible." The requirement for political independence of the central bank was seen to be derived from "time inconsistency" whereby the median voter, as represented by politicians, would want to curb central bankers who impose economic pain by tightening monetary policy to lower inflation and inflation expectations.

That said, the U.S. Congress did attempt to temper Federal Reserve independence by passing in 1978 the Humphrey-Hawkins bill that required it to target stable inflation and low unemployment. Humphrey-Hawkins, however, did not constrain Paul Volcker, who in 1980 allowed the Fed funds rate to rise above 20 percent by adopting tighter quantitative reserve targets and letting markets determine interest rates. Newspaper advertisements that protested Volcker's stringency--and potentially threatened Fed independence--showed the Fed chairman ripping intravenous tubes out of the body of a struggling economy and its unemployed workers.

However, once the inflation rate had fallen from 15 percent in early 1980 to below 3 percent by 1983 while growth recovered, the case for low and stable inflation had been made. The "great moderation" was to follow with less volatility, steady growth, and low and stable inflation as a testament to the benefits of Fed independence.

By the time the Alesina and Summers article appeared in 1993, the independent central bank had come to mean economic stability and positive effects on growth that derived from two sources. First, more stable inflation meant lower inflation volatility that contributed to growth by lowering real interest rates (lower risk premiums) and stabilizing relative prices. Empirical evidence had supported the positive real growth effects of lower and more stable inflation. Second, the fear of unstable accelerating inflation that had grown up in the late 1970s as the Fed was trying ever-rising doses of easier money to push down the unemployment rate was buried.

The great moderation was seen by many as a beneficial byproduct of the Fed having abandoned the attempt to target real variables such as unemployment. The Friedman-Phelps natural rate hypothesis ruled, and the Fed was largely free in effect to focus on achieving low and stable inflation. Even the natural rate of unemployment (NAIRU, or non-accelerating inflation rate of unemployment) drifted downward during the 1990s, so that the threshold at which lower unemployment increased inflation risks was relaxed by Alan Greenspan.

Moving forward from the experience since 2008, the important thing to remember when gauging the negative response, and the rising threat to Fed independence that has grown out of the Fed's role in TARP and especially QE2, is the sharp and unpredictable change in the role required of the central bank during and after a financial...