Who will win the battle for the soul of the US Federal Reserve?

America's 96-year-old central bank is considered too independent by those who want it under tighter government control. Stephen Foley reports
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The Independent Online

It is shaping up to be a ferocious fight. Ranged on one side is the entire Republican membership of the US House of Representatives. On the other are many of the most influential economists in the land. In the middle is mild-mannered Ben Bernanke, the chairman of the Federal Reserve. After months of phoney wars and petty skirmishes, this is the big one – the battle for the soul of the Fed.

Leading the charge, in his 19th-century pith helmet, is the unlikely figure of Ron Paul, the libertarian congressman who, for a generation, has been knocking about on the fringes of his party, arguing that it was a terrible error to have created the Fed in the first place, back in 1913. Suddenly, he seems to be surfing a mood among part of the political class. It is time, he says, to bring some political accountability to the over-mighty central bank.

Not so fast, say the massed ranks of economists, marching under the "Fed independence" banner. Politicians meddle in the operations of the central bank at the nation's peril. When the Fed is pumping more money than ever into the fragile credit markets, inflation-wary global investors will punish any hint that its actions could become heavily politicised.

The irony is that both sides are fighting for the same ultimate goal: the suppression of inflation.

Close followers of last year's US presidential election will have noticed Mr Paul, the 73-year-old representative from Texas, during the Republican primaries. His small-government rhetoric, non-interventionist foreign policy and socially liberal views – and his embrace of internet campaigning – won him a large following among the party's young, even though he never garnered enough support to challenge the frontrunners for the nomination.

Mr Paul is a hard-money conservative, who advocates something akin to a return to the gold standard as a means of preventing the government – via the Fed – printing money. Most of the 271 congressmen who have signed up to support his bill to audit the Fed do not agree with that policy; but they are scared, nonetheless, about what the Fed has been able to do over the course of the credit crisis without ever asking for Congress's permission. The bailouts of Bear Stearns, AIG and Bank of America were all cooked up behind closed doors, and public fury has been immense. Meanwhile, the Fed's balance sheet has swelled past $2trn, as it flooded the credit markets with newly printed money, and many congressmen fear the inflationary consequences if that cash is not pulled out quickly.

It has seemed for some time that Mr Bernanke has been aware of the political risks. In March, the chairman gave CBS television's 60 Minutes unprecedented access to the Fed, and even took journalists back to his home town of Dillon, South Carolina. There, the chairman said explicitly: I am not a Wall Street guy and I am bailing out Wall Street for one reason only – to help towns like this. Having initially planned to run the Fed in a low-profile, collegiate fashion and eschew the personality cult of his predecessor, Alan Greenspan, the idea seemed to be to burnish his personal credentials.

Mr Greenspan was so famous and so respected that no one dared question the Fed's independence, and indeed the Clinton administration was cowed into bringing down its deficits largely because of pressure by Mr Greenspan. But that seems an unlikely state of affairs now, a decade and a half later. The Fed is being criticised as never before – among other alleged sins, for inflating a housing bubble and for failing to regulate mortgages properly.

Stir into the mix the fact that the Obama administration is now asking for the Fed to be given wide new powers to oversee financial firms deemed "too big to fail", and you have a ferment on Capitol Hill that shows no sign of abating. In unprecedented scenes last month, Mr Bernanke was repeatedly interrupted and harangued by lawmakers when he gave testimony on Bank of America's acquisition of Merrill Lynch, which had to be supported with $20bn in taxpayer funds. BofA was pressed hard by the Fed and the Treasury department to consummate the deal, even though it had doubts because of Merrill's spiralling losses; Mr Bernanke had repeatedly to deny that he threatened BofA's management with the sack.

Immediately afterwards, a cross-party group of congressmen wrote to the White House demanding a halt to plans to give new power to the Fed until Mr Bernanke and his officials were cleared of wrongdoing over BofA.

The political pressure on Mr Bernanke is intense, which is why his own position is the subject of so much speculation. His term is up in January, and while the betting is that he will be reappointed, the Obama administration has given no early sign that it intends to do so. Whatever the President decides, the decision will be informed by the ferocious debate about whether the Fed is out of political control and needs to be reined in – or is not independent enough.

Mr Paul's bill would bring the Fed under the auspices of the Government Accountability Office and create an audit of all the central bank's activities. "Since its inception, the Federal Reserve has always operated in the shadows, without sufficient scrutiny or oversight of its operations," the congressman said, introducing his bill. "While the conventional excuse is that this is intended to reduce the Fed's susceptibility to political pressures, the reality is that the Fed acts as a foil for the government."

The very suggestion of an audit by Congress, opening the Fed's day-to-day operations in the money markets up to political scrutiny, has alarmed professional and academic economists. It would be a huge chip in the Fed's independence, without which the bank would be under constant pressure to expand the economy, even if it was starting to get overheated.

"The Fed is plenty accountable already," said Kevin Logan, senior US economist at Dresdner Kleinwort, one of more than 250 signatories to a petition against Mr Paul's movement. "The chairman comes to Congress for two sessions of testimony every year, all the board members are appointed by the White House and approved by Congress, and the chairman only serves for a four-year term."

Economists, said Mr Logan, had determined to come out fighting. "You've got to give some consideration as to why the Fed has its independence in the first place. If you don't express your view, and the other side is so vehement, then it could potentially carry the day."

The petition has been signed by three winners of the Nobel Prize in Economics and five former presidents of the American Economic Association, as well as the current president, Angus Deaton of Princeton University, and the president-elect, Robert Hall of Stanford University. Two former Fed governors are also on the list.

"The independence of US monetary policy is at risk," the petition bluntly declares. "Central bank independence has been shown to be essential for controlling inflation. Sooner or later, the Fed will have to scale back its current unprecedented monetary accommodation. When the Federal Reserve judges it time to begin tightening monetary conditions, it must be allowed to do so without interference. Second, lender of last resort decisions should not be politicised."

Donald Kohn, Mr Bernanke's deputy, also came out fighting, saying the inflation-busting credentials of its independent central bank were one reason the US has a good credit rating and global investors demand only relatively modest interest rates. That could change if Mr Paul's coalition prevailed, he suggested.

Right-wing commentators went wild. By suggesting that interest rates would rise if there was more political oversight of the Fed, Mr Kohn was "holding the American people to ransom", it was said. The signatories to the economists' petition have been deluged with emails from angry opponents. The independence or otherwise of monetary policy and policymakers has not inflamed such passions since the Fed was created 96 years ago. It promises to be an explosive battle.

How it works: Inside 33 Liberty Street, New York

Created by the 1913 Federal Reserve Act, a compromise that split control between bankers and government appointees, and dispersed authority to regional organisations.

Has the ability to expand the money supply, by printing money, and to contract it. It can also to set US interest rates to stabilise the economy and maximise employment.

Twelve regional Federal Reserve Banks are technically owned by the local banks which are members and appoint one-third of the regional governors.

The central board of governors are appointed by the President for 14-year terms, and have to be approved by Congress.

Acts as lender of last resort to member banks, and demands it holds a portion of their deposits, to prevent the panics that plagued the US in the 1800s and early 1900s.

The Federal Open Market Committee, which sets US interest rates, comprises the board of governors and a rotating group of regional bank presidents.