'Voting' to Audit the Fed

Abstract

Federal Reserve independence is a chimera. We derive and test predictions about when members of Congress will support legislation to curtail the Fed’s powers and independence. We posit that members of Congress have partisan monetary policy preferences (Democrats like loose policy, Republicans like tight policy) and will support such legislation when the Fed pursues policies that are in tension with their own party preferences. We model the Fed as a strategic agent of Congress with hawkish preferences of its own that are closer to Republicans than to Democrats. We make predictions about the propensity of members of Congress to co-sponsor attacks on the Fed based on whether members are naïve or sophisticated with respect to the Fed’s partisan bias. If members of Congress are naïve and do not anticipate that the Fed can adjust its policy to influence presidential electoral outcomes, then the propensity to threaten to audit the Fed should be based strictly on partisan identity: Naïve Democrats (Republicans) should always respond to increases in the Federal Funds Rate by increasing (decreasing) their propensity to co-sponsor attacks. However, if members of Congress are sophisticated and understand that the Fed acts strategically to aid in the election or re-election of Republican presidential candidates, then the relationship between the Federal Funds rate and the tendency to threaten the Fed should be moderated by both the electoral calendar and the party of the president: Republicans (Democrats) won’t attack (reward) the Fed when it loosens policy late in the term of a Republican president because they understand the Fed is actively engaged in aiding the electoral efforts of Republican presidential candidates. Our results suggest that House Democrats are sophisticated partisans, Senate Democrats are naïve partisans, and the behavior of Republicans in both chambers is inconsistent with the partisan model.

Keywords: Federal Reserve, Congress, Central Bank Independence, Monetary Policy

JEL Classification: E, E52, E58