Meltzer: Federal Reserve Indepedence

From the Introduction:

What does “independent” mean when the Federal Reserve is called an independent
agency? The question is not one that the Federal Reserve or others try to answer, so we must look at what it does to supplement its few efforts to define independence. The answer is mixed. Any agency that can quadruple the size of its balance sheet without oversight over four or five years, as the Fed has just done, has considerable freedom or independence. Yet, many of the increased services, more than 40 percent, went to finance the outsized budget deficits during the period. Independent central banks do not finance budget deficits.

In fact, the original Federal Reserve Act in 1913, did not permit any Federal Reserve support of the Treasury. For the founders, an independent central bank followed a gold standard rule and also a rule that prohibited financing the Treasury and the budget. Those two rules supported an independent Federal Reserve during the 1920s. After surrendering independence to finance World War I and accepting control by the Treasury and administration in the early postwar, the Federal Reserve restored its independence by restoring the gold exchange standard.  That standard was a weaker type of gold standard that became an operating rule. The Fed worked to expand the gold exchange standard internationally. The U.S. did not leave the standard until 1934, but it did not monetize gold inflows in 1930-32, a mistake but made independently.

The prohibition against financing the Treasury did not last long. By 1923, the Reserve Banks, subject to Board approval, bought and sold Treasury issues to change bank reserves. Once open market operations became the principal means of implementing monetary policy, the Federal Reserve could buy new Treasury issues, not directly from Treasury, but in the market.

Legally the Federal Reserve remained an independent agency. Once the two rules were no longer binding, independence lost much of its meaning. As Milton Friedman claimed (Friedman, 1959), and Thomas Cargill recently documented (Cargill, 2014), it is a rule that restricts Federal Reserve actions. And it is the decision to follow a rule that maintains central bank independence.