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Operation ‘Arm Twist’

By Patrick Van Horn · Bankrate.com
Monday, October 3, 2011
Posted: 12 pm ET

Last week Ben Bernanke, the Chairman of Federal Reserve, announced what has been referred to as Operation Twist. In short, the Fed will roll over the short-term bond purchases they made as they mature and purchase long-term bonds in order to push interest rates down on mortgages and long term debt.

But arguably just as important was how the Fed resisted the most blatant public attempt by politicians to influence monetary policy in decades. That pressure came in the form of a letter released by four top Republican politicians prior to the announcement by the Fed. Signing the letter, which was published in major newspapers across the country, were Senate Minority Leader Mitch McConnell, R-Ky.; Minority Whip Jon Kyl, R-Ariz.; House Speaker John Boehner, R-Ohio; and Majority Leader Eric Cantor, R-Va.

Bernanke, himself a Republican, and the majority of the members of the Federal Open Market Committee decided to ignore the pressure from the Republican leaders and pursue a new plan to encourage economic growth. This effort of Congressional leaders endangers one of the most important aspects of a well-functioning central bank: independence.

Monetary policy and central banks like the Fed should be free from all political influences. In the past, politicians have influenced the Fed to adopt policies which benefit them  in the short-run. However, these actions led to policy outcomes that weren't desirable once enacted. History can provide a backdrop of this.

During World War II, the Federal Reserve cooperated with the Treasury to keep interest rates on government bonds pegged to low levels, which reduced the interest expense of the debt used to finance the war. When the U.S. entered the Korean War, President Harry Truman again requested the Fed peg interest rates to extremely low levels. By the time the role of the U.S. in Korea intensified, inflation rates were already increasing. The Fed realized it was feeding these high rates of inflation by keeping interest rates low and decided it was responsible monetary policy to lower those high rates of inflation.

In 1951, the Federal Reserve and the Treasury reached what became known as the Accord. The Accord specifically freed the Fed from monetizing the debt and enabled the Fed to act independently from the federal government when deciding on monetary policy. Inflation began to fall immediately after the Accord as the Fed no longer pegged interest rates to very low levels.The Fed would retain that level of independence until President Lyndon Johnson pressured, and finally convinced, Fed Chairman William McChesney Martin, Jr. to lower interest rates to spur economic growth in the mid-1960s.

The result was a higher rate of inflation that began in the late 1960s and grew worse in the 1970s. The high rates of inflation persisted until the early 1980s. Only then did Paul Volcker, chairman of the Federal Reserve at the time, reassert the Fed's independence by increasing interest rates to curb high inflation.While higher rates of unemployment and lower levels of the gross domestic product, or GDP, followed, Volcker knew that the effects of the high rates of inflation would be much more damaging in the long run if he was pressured by politicians to relinquish his war on inflation. This defining moment in Fed independence eventually led to one of the largest economic booms since World War II.The Fed enjoyed a reprieve from political pressure -- at least in the public eye -- throughout the Clinton and Bush administrations. This is why this recent attempt by Congressional leaders to influence monetary policy came as such as surprise.

But if history has shown us anything, it's that monetary policy is much too important to be left to politicians.

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2 Comments
TheForexBus
October 29, 2011 at 1:36 pm

Interesting "twist" like someones arm! The thing is close to implode sooner than we think. It is like once a Monopoly gamer has won all the money from his other players, he enjoys the control. But who is at the end than buying his holdings once they are out of money! Lol Twist my arm yes that is what everybody is asking the Feds. The magic wand in hand of a B.B waived at the Congress members that they are blind!

Patrick
October 13, 2011 at 7:31 pm

Well I'm voting straight Tea Party.
When banks record billions in profits
and the middle class is expected to
spend their principal...it just doesn't
equate. I think they're going to have
alot of new congressman to retrain to
replace anybody that confirmed Bernanke.
Propaganda can only succeed so far.