The Fed’s decision to begin open-ended purchases of Fannie Mae and Freddie Mac mortgage-backed securities comes on the heels of the European Central Bank’s decision to purchase unlimited quantities of short-duration government bonds across the euro zone.
The ultimate goal of the central banks’ action is to influence the prices and yields of financial assets. In turn, they hope to have an impact on households and businesses by lowering borrowing costs and encouraging an increase in spending to boost GDP.
However, there is a growing worry that these actions can’t solve the underlying problem and that the returns on these actions are diminishing fast. Against this backdrop, fiscal authorities are warning that they see central bankers and the decisions that emerge from their closed meetings as going “deeper and deeper into fiscal-type waters,” jeopardizing central bank independence. As John Cochrane has noted, “central banking really is the last refuge of central planners, which should embolden [us] to search for rules, institutions, and mechanisms to do a better job.”
The only solution now may be for a new accord between central banks and governments, an idea put forward by Professor Marvin Goodfriend of Carnegie Mellon. The premise is that the U.S. Congress has supported the Fed’s independence insofar as it has been a necessary precondition for the Fed to do an effective job. “Hence, the Fed should perform only those functions that must be carried out by an independent central bank,” writes Goodfriend.
The principles in the accord should acknowledge that purchases of long-duration bonds introduce interest rate risk and fair value losses. A commitment should be made that credit-related initiatives occur only with the permission of fiscal authorities.