Fed: A Rising "Audit" Risk

Published on February 5, 2015

As immensely difficult and fraught with risks as it may be for the Federal Open Market Committee over the next few months in weighing the timing to a rates lift-off, those calculations are about to become even more complicated with new and very real near term political risks.

Indeed, as soon as her Humphrey Hawkins testimonies later this month, and building through the first half of this year in a number of planned hearings, Fed Chair Janet Yellen and her FOMC colleagues will find themselves increasingly caught in a political crossfire between the Republican Party’s Capitol Hill leadership and its far-right Tea Party wing, who will be pressing a populist critique of the central bank’s “secretive” unconventional policy measures they argue have only benefited the wealthy and the biggest of the big banks to the detriment of most Americans and especially the elderly and savers.

*** The flashpoint is a swelling political momentum behind the so-called “Audit the Fed” bill that was recently re-introduced as S.264 by Rand Paul, the Kentucky Republican Senator and presidential candidate. Once seen as a fringe issue, it has within the last few weeks swollen into a major rallying cry for the Tea Party wing and it has, surprisingly at first glance, garnered 30 co-sponsors including Senate Majority Leader Mitch McConnell and even a handful of moderate Republican Senators. The bill got a major boost last week when Senate Banking Committee Chairman Richard Shelby promised that hearings on “Audit the Fed” would be scheduled in the spring. ***

*** The GOP leadership is unlikely to initially defend the Fed, at least until they see how Chair Yellen handles her testimonies and how effectively the Fed marshals its own lobbying efforts. Instead, the pivotal player on the frontline will be Shelby, the powerful Senate Banking Committee chairman. Shelby’s motives are varied, and he has in effect taken ownership of the bill, in theory limiting the risk of lasting damage to the Fed. But he is at the same time likely use it as leverage for a tough oversight of the central bank and to extract concessions from both the Fed and the White House on tweaks to Dodd Frank, albeit through a strategy that may entail hard-to-control consequences. ***

*** The Audit the Fed bill is not really about an audit as it is the means by which Congress seeks access to the FOMC’s monetary policy decisions. And that President Obama has already vowed a veto is almost beside the point, for its damage will come long before that. Hearings on the Audit the Fed bill and similar efforts — Congress also intends to investigate the Federal Reserve Bank of New York’s operational distance (or the lack thereof) from the banks its oversees — will invariably put the Fed on the defensive and could put a darker political skew to the Fed’s near term rate decisions, potentially generating doubts over its operational independence and elevating market volatility. ***

GOP Divisions and the Audit bill

The Republican Party’s resounding wins in November to retake control of the Senate and build on its House majority notwithstanding, its internal tensions between the Capitol Hill leadership and mainstream base, and Tea Party and libertarian right wing, remain as fractious as ever.

The almost hapless political storm several of its 2016 presidential candidates got themselves into over something as seemingly noncontroversial as vaccinations against polio or measles testifies to that. Inside Congress, the party still seems unable to resolve its differences over immigration policy, imperilling an extension of funding for the Department of Homeland Security before its February 27 deadline (see SGH 1/21/15, “US: Looking Beyond SOTU”).

In the past, House Speaker John Boehner sought to manage and steer his class of 2010 Tea Party faction by giving them just enough rope to push bills that had no chance of becoming law, since the Democratic-controlled Senate would ignore or quietly kill them, in the hopes bills with a better chance of bi-partisan support could follow. The strategy, however, often backfired, such as in the government shutdown of 2013.

But the new GOP Senate leadership looks in some sense to be picking up from the Boehner playbook in how it has decided to handle the groundswell of support within the Republican ranks and its base in recent weeks for the “Audit the Fed” bill its sponsor Senator Paul has re-introduced as “The Federal Reserve Transparency Act of 2015.”

As every Fed Chair has rarely missed the opportunity to stress — and Chair Yellen is guaranteed to repeat the message in her upcoming testimonies on Capitol Hill — the Fed and its twelve district banks are all currently audited by the General Accounting Office, by the Office of Inspector General, and by private auditing firms. Its balance sheet holdings are published weekly online. The FOMC in fact seems to have discussed the Audit bill in its January meeting, and the risk of its harm to policy seems to crop up in other remarks by FOMC members, most notably in the remarks yesterday by Federal Reserve Bank of Cleveland President Loretta Mester.

Under current law, the GAO is restricted in its audit from access to anything related to the FOMC’s monetary policy deliberations, its communications to the Open Market Desk in New York, or the specifics of the actual execution of policy in the Desk’s market operations. The main takeaway of the Audit bill as drafted is that it would revoke those restrictions to allow for a “more thorough evaluation of policy decisions” to be passed on to Congress for comment and assessment.

The bill, in other words, is not really about an audit nor transparency as much as it is the means by which Congress would gain access to and be able to influence in near real time the FOMC’s policy decisions and decision making process on both regulatory and monetary policy. It is not hard to envision what impact that would inevitably have on the market’s perception of monetary policy independence.

But the bill does reflect and channel the populist anger over the sub-par nature of the post 2009 recovery and the lingering conspiratorial accusations the central bank has been “secretive” in its unconventional policy measures, “bailing out” the big banks and corporations, accumulating trillions in “hidden liabilities” on its balance sheet, “stoking a stock market that only benefits the wealthy and Wall Street” while interest rates are being kept artificially low, stoking inflation down the road and hurting the elderly and those living off their savings. The “Audit the Fed” bill promises to bring the central bank to heel.

The GOP leadership’s strategy to take ownership of the bill, perhaps watering down its more extreme edges in the legislative process, is underscored in the list of co-sponsors to the Paul bill. Many signed up rather than confront the party’s right wing for no purpose in the near term, and depending on how the bill evolves, it may also offer opportunities to extract concessions from the central bank, or more to the point, the White House.

The leadership for that reason is likewise unlikely to defend the Fed in the initial stages of the bill’s debate, and there will be inevitable questions raised about some of the issues in the bill in the questioning of Chair Yellen later this month in the Humphrey Hawkins testimonies.

The Fed, of course, has often been a target of GOP criticism ever since it turned to unconventional policy measures in the wake of 2008 financial crisis, especially in the more unwieldy and populist House Financial Services Committee. But the nexus point where Capitol Hill politics and Fed policy will intersect is now in the Senate Banking Committee, and the crucial power player in the unfolding political drama will be Shelby, its powerful chairman.

Shelby’s Agenda

Shelby is a 30-year veteran of the Senate and is considered one of the toughest, best negotiators on Capitol Hill. He previously served as Banking Committee chairman when the Republicans last controlled the Senate in 2006-2008. He is a conservative with a strong populist streak who takes his jurisdiction seriously, and has proven he can reach across the aisle to cut deals with Democrats on the issues he feels most passionately about, among them a strong regulatory oversight of Wall Street and the big banks – and in keeping a critical eye on the Fed.

He has sharply questioned the Fed’s alleged “easy money” policies of its Large Scale Asset Programs, has repeatedly criticized its lax oversight of the banking system, and in 2010 he was a pivotal player in blocking labor economist Peter Diamond as President Obama’s nominee to the Fed’s Board of Governors. Shelby’s sharp disapproval was based on what he considered to be the Nobel Prize winning Diamond’s “excessive Keynesian leanings.” That dislike of Keynes and an accusation of being too soft on regulation also led Shelby to vote against Yellen’s confirmation – twice – as Vice Chair in 2010, and as Chair in 2013.

And now, with Shelby elevating the prospects of the bill with planned hearings to debate its merits, the “Audit the Fed” bill has made its way from a Republican slipstream into the main currents of its economic policies. In effect, by taking ownership of the bill, Shelby is taking it out of the hands of a fringe libertarian like Paul to give it far more legitimacy and better odds of becoming law, or at least a bill put to President Obama to veto, or even more likely, a vehicle to extract concessions elsewhere in the politics that will be unfolding by late spring or early summer.

It has to be said Shelby does not necessarily support the bill as written – he certainly wants to put it through the committee process – and he is said to be well aware of the market sensitivity to the appearance of undercutting Fed independence, and to have no intention of micro-managing the Fed.

But he also strongly believes Congress should increase its oversight of the central bank ever since it undertook its unconventional policy measures and pushed its mandate into borderline fiscal policy; he has a particular interest in its balance sheet management, what securities are in its portfolio, and what the Fed is intending to do with its balance sheet down the road. As he put it last week in remarks to the press, he is interested “in some type of audit of the Fed, especially their portfolio.”

Shelby is notorious for playing his cards close to his chest, and his legislative ambitions will only unfold as his Committee hearings progress towards where a deal is most likely that brings in enough Democrats to the majority Republican-control of the Committee and the Senate itself to get a bill passed and into law.

He may use the bill as leverage to keep up the political pressure on the Fed and the White House to ensure neither “goes soft” on the oversight of the “too big to fail” banks, or to further exempt smaller regional and community banks from some of the more onerous reporting and capital requirements of Dodd-Frank. Indeed, that may well prove to be where a compromise is found to ease back on the worst aspects of the Audit the Fed bill or to let the bill fade in committee.

But until then, there are not insignificant political risks to the Fed, headline risks if anything else, over the next few months when the “Audit the Fed” bill will be debated and the political spotlight is brought to bear on the Fed’s rate decisions and management of the balance sheet.

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