Why Is the Federal Reserve Independent?

Many people are surprised to learn that the central bank of the United States, the Federal Reserve ("the Fed," for short), operates for the most part independently of the federal government. But the Fed is also a quasi-governmental agency with a board of governors selected by the President and approved by Congress. The combined public and private structure of the Federal Reserve remains highly controversial, especially in the aftermath of the financial crisis of 2007–2008. 

The role of the Fed as the central bank in the U.S. and its position of influence highlights the question of whether or not central banks should be independent from the political bias of government.

The Fed as Quasi-Governmental

The independence of America's central bank has always been a contentious issue. In the early days of the Republic, the founding fathers ultimately opted against having a central monetary authority. Although Alexander Hamilton was successful at establishing the Bank of the United States for several years, it ultimately failed. It was not until the Federal Reserve Act of 1913 that established the present-day central bank.

Prior to the Fed, recessions and financial panics were commonplace as investors and depositors could not be sure of the stability and solvency of the banking system. Indeed, private financiers like J.P. Morgan had to bail out the American banking system in 1895 in the absence of a central bank to act as lender of last resort. The Federal Reserve Act sought to bring stability to the financial sector and centralize monetary policy under a single authority.

The monetary decisions of the Federal Reserve are meant to be separate from the government, and policy moves do not have to be ratified by the President, or anyone else in the Executive Branch. The Fed receives no direct funding from Congress, and the members of the Board of Governors, who are appointed, serve 14-year terms. These terms do not coincide with presidential terms, creating additional independence.

However, the Federal Reserve is subject to some oversight by Congress, which aims to ensure it achieves the economic objectives of maximum employment and stable prices. In addition, the Fed Chair must submit a semi-annual report on monetary policy to Congress.

Why Be Independent?

The primary justification for an independent Federal Reserve is that it's necessary to insulate system from short-term political pressures. Without a degree of autonomy, the Fed could be influenced by election-focused politicians. For example, it could be pressured into enacting an excessively expansionary monetary policy to lower unemployment in the short term, which may later lead to high inflation and fail to control unemployment over the long term.

Indeed, proponents of central bank independence argue that political pressure is too great to let it interfere with monetary policy and macroeconomic decision-making. In particular, politicians have short-term goals of re-election, which tend to favor inflationary policies that give the illusion of boosting wages and employment, but at the expense of longer-term growth. Furthermore, inflation can undermine the purchasing power of currency and harm creditors and savers.

Advocates of autonomy thus argue that an independent Fed can better address long-term economic objectives. Independence can also make it easier to execute policies that are politically unpopular but serve a greater public interest. Another argument is that the central bank should be filled with economists and other experts, rather than politicians or those under political sway.

Arguments Against Independence

Critics argue that it is unconstitutional for Congress to assign monetary power to an independent quasi-governmental agency. According to the Constitution, Congress has the power to coin money and regulate its value. In 1913, Congress delegated this power to the Fed through the 1913 Federal Reserve Act. However, some argue that such a delegation is fundamentally unconstitutional. Opponents of the Fed's independence also suggest that it is undemocratic to have an unelected agency, unaccountable to the US public, dictating monetary policy. 

Another argument against independence is that it fosters poor coordination between the fiscal policy put in place by Congress—including taxation and spending—and the monetary policy enacted by central banks. For instance, if the government is cutting taxes (loose fiscal policy), but the central bank is raising interest rates (tight monetary policy), this can create a mismatch that undermines both's efforts.

The Bottom Line

The Federal Reserve occupies a unique role, operating both independently of the federal government while still being subject to some oversight. The agency is governed by a board whose members are selected by the President and approved by Congress. However, the Fed is also independent in the sense that it conducts monetary policy and related decision-making autonomously. Because of its quasi-governmental status, the Fed has faced critism from some who argue that it's unconstitutional for monetary policy to be designated to an unelected agency, unaccountable to the public. On the other hand, there are many who argue that the Fed's independence is critical to its ability to set long term monetary policy outside the influence of short-term politcs.