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Federal Reserve and Republican critics may compromise on oversight after Trump win

[December 12, 2016] By Jonathan Spicer

NEW YORK (Reuters) - Republican lawmakers and the Federal Reserve may be ready to strike a compromise deal on legislation that would give Congress greater scrutiny over the central bank, now that there is no longer the threat of a presidential veto, but it would likely stop short of dictating rules on setting interest rates.

Donald Trump's victory in the presidential election will give the Republicans control over both the White House as well as both houses of Congress next month, removing a likely veto on legislation to overhaul governance of the Fed by a Democratic president. Even so, Republicans will need support from Senate Democrats now that their Senate majority has shrunk to a 52-48 split in the November polls.

Republicans who have been pushing for limits on the Fed's ability to decide policy believe the central bank has overstepped its mandate by using extraordinary measures to stimulate the economy since the financial crisis, and they say reforms are a priority next year. Interviews with lawmakers, aides and top Fed officials indicate there could be common ground for a deal, marking a possible departure from the central bank's resolute opposition to reform.

"There are different paths to a workable solution," said Representative Bill Huizenga, a Republican who chairs the House of Representatives subcommittee on Monetary Policy and Trade.

Huizenga, who last year introduced legislation to tie policy decisions to a benchmark rule or risk "audits" by a congressional watchdog, told Reuters that he was "open to what exactly" the audits would look like. "But it needs to be early, if not the first thing that we do."

The Trump administration and the Federal Reserve declined to comment on the potential for legislation or their positions.

Huizenga's bill last year would force the Fed to operate under a directive rule like the one named after conservative economist John Taylor, which prescribes interest rates based on levels of inflation, employment and growth.

That would be a sea change from the way the Fed has long operated, in which it reviews economic conditions as it weighs decisions on interest rates, but is free to set policy as it deems appropriate.

The bill would leave room for discretion but would open the door for Congress to launch real-time reviews of rate decisions if the central bank strayed too far from the rule, something Fed Chair Janet Yellen called a "grave mistake" that would damage the bank's credibility and distract its focus on longer term economic goals.

Under a strict Taylor rule, the key federal funds rate - the rate at which banks lend money to other banks on an overnight basis - would be one to two percentage points higher now than it is, based on calculations by the Federal Reserve Bank of Cleveland.

Huizenga's proposal is now part of a broader bill championed by Jeb Hensarling, the influential Republican chair of the House Financial Services Committee, to winnow back financial regulations. Hensarling has called Fed reform a top priority and said he was willing to negotiate.

Because any such legislation would typically require a supermajority to pass the Senate, Republicans - who now hold only a simple majority - will need to compromise in order to win the support of some Democrats.

TRANSPARENCY VS OVERSIGHT

The Fed could find other ways to satisfy demands for more insight. It could use its existing semi-annual reports to Congress to cite an array of well-known monetary policy rules and explain how it arrived at its decisions with reference to those rules.

That could provide the desired transparency and even side-step the threat of probes by a congressional watchdog.

Another alternative would be to make these audits scheduled, and not ad hoc, which could help curb any partisan challenges to policy in real-time and preserve the Fed's flexibility during crises.

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Still, those regular reviews would allow Congress to see how Federal Reserve policymakers sifted through economic data and forecasts to reach rate decisions. Now that the Fed has begun raising rates, Republicans complain it has offered a shifting set of reasons to move slowly, including political turmoil and market volatility overseas.

A hint of how compromise could be achieved came this summer when the Cleveland Fed published a list of seven well-known policy rules and showed that their recommended rates varied between 0.14 percent and 3.08 percent.

The Fed's policy rate is now 0.25-0.5 percent and is expected to rise a quarter point this week.

"We do look at a number of rules ... but monetary policy isn't a simple thing," Cleveland Fed President Loretta Mester said in a recent interview. "I hope that any change that Congress pushes through is done in a thoughtful way and doesn't disrupt the benefits that we have in the current system."

While there is no explicit reference to the Fed's swollen balance sheet in proposed legislation, Hensarling and other critics have called for a firm plan to sell off the $3.5 trillion in Treasury and mortgage bonds the central bank amassed in the wake of the 2008 financial crisis. The bond purchases were extraordinary measures taken to stimulate growth.

Many Republican lawmakers say bond purchases inappropriately increases the Fed's role in the economy and amounts to financing of the government, a measure that is banned under statutes. Critics say the Fed's plan to shed assets once interest rates have started normalizing is too vague, suggesting that could work its way into increased congressional oversight.

HOLDING THE FED TO ACCOUNT

The Fed maintains that its policies have been transparent in the face of a deep recession and frustratingly slow recovery.

Yellen and her colleagues also say the Fed can best achieve its twin mandate of price stability, which it targets at 2 percent inflation, and maximum sustainable employment when free of short-term political interference. It is close to both goals now.

Taken together, Republicans' pursuit of reforms makes future Fed policy "a big global uncertainty," said Peter Hooper, a former Fed official who is chief economist at Deutsche Bank Securities. It could lead to more aggressive rate hikes than the roughly two-per-year currently expected, and quicker trimming of the balance sheet, he said.

Selling bonds, or even halting purchases of those maturing, would raise market yields and amount to tighter monetary conditions.

Getting a Fed-reform bill into Trump's hands "will require a consensus," said Representative Frank Lucas, another Republican on the House Monetary Policy subcommittee. "To get there we would need to explain to the Senate that this would not constrain the Fed in any future crisis."

Lucas acknowledged concerns that the Taylor rule would "dramatically alter" the Fed's flexibility, and told Reuters his staff was considering possible adjustments to proposed bills.

That would appear to be something Huizenga could live with.

"They are already doing the analysis, so maybe it's asking them to share that analysis," Huizenga told Reuters, adding he hoped the election of Trump caused Fed leadership to "rethink its stiff-arming" of reforms.

(Editing by David Chance and Leslie Adler)

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