FRBSF Weekly Letter
96-08; February 23, 1996
The President and Congress are directly responsible for fiscal policy,
but Congress has chosen (through the Federal Reserve Act) to delegate
authority for monetary policy to the Federal Reserve System. Furthermore,
it has granted the Federal Reserve a substantial degree of independence.
Decisions about monetary policy are made by the Federal Open Market Committee
(FOMC), which consists of 7 Governors, who are appointed by the President
and confirmed by Congress, and 12 regional bank Presidents, who are chosen
jointly by the Federal Reserve Board and the boards of the regional banks.
On a short-term basis, FOMC decisions are largely independent of direct
input from the President or Congress. And since members of the FOMC serve
long terms and do not stand for election, they are largely insulated from
the political process.
Why did the founders of the Federal Reserve choose to insulate the central
bank in this manner? One possibility is that they were concerned that
there would be an inflationary bias if monetary policy were too strongly
influenced by elected officials. The empirical evidence suggests that
this concern is warranted: across countries, there appears to be an inverse
relation between average inflation and the degree of central bank independence
(for example, see Alesina 1988 and Grilli, Masciandaro, and Tabellini
1991). But what is it about the political process that tends to create
an inflationary bias? A recent paper by Jon Faust (1996) provides an intriguing
answer, and this Weekly Letter discusses his arguments.
In most circumstances, our system of government favors the rule of simple
majorities as a way to decentralize political power, but this preference
is far from universal. There are any number of examples in which governmental
decisions are insulated to a greater or lesser extent from the rule of
simple majorities. The best example is the U.S. Supreme Court. Like the
Federal Reserve Board, Supreme Court Justices are nominated by the President
and confirmed by Congress but do not stand for election. They serve life
terms, and they can't be fired for rendering unpopular decisions. Hence,
in the short run, the Supreme Court is largely insulated from the will
of the electorate.
The rationale for having an independent Supreme Court is a belief that
majority rule may sometimes produce undesirable outcomes. For example,
in times of crisis, a majority of voters might be persuaded to temporarily
suspend certain fundamental rights, such as that of free speech or assembly.
While such an action might appear to be expedient, it might prove to be
difficult to reverse once the crisis has passed. Once rights are suspended,
they may be difficult to restore. There is also a moral hazard problem:
some factions in society might provoke a crisis in order to undermine
public support for basic rights. An independent Supreme Court limits the
power of transient majorities to alter certain fundamental aspects of
our political system and thus contributes to its long-term stability.
In the language of Alexis de Tocqueville (1969), an independent Supreme
Court helps to protect against the "tyranny of the majority."
Can the same be said for an independent central bank? Faust argues that
The first step in his argument concerns the effects of unexpected inflation
on the distribution of wealth. In the United States, most debt contracts
are written in nominal terms. A creditor agrees to lend a sum of money
at a given nominal interest rate for a given period of time, and the borrower
agrees to repay the principal plus interest at maturity. The interest
payment consists of two components. First, borrowers must pay something
in order to persuade lenders to part with their capital for the term of
the loan. Second, inflation erodes the real value of the principal during
the term of the loan, and borrowers must compensate lenders for this loss.
Since the nominal interest rate is typically set at the beginning of the
loan, the compensation for the erosion of purchasing power must reflect
expected inflation, rather than actual inflation. These two components
are reflected in the Fisher equation, which states that the nominal interest
rate is equal to the real interest rate (payment for use of capital) plus
the expected inflation rate (compensation for the erosion of purchasing
If expectations turn out to be correct, then the inflation compensation
that was agreed upon at the beginning of the loan exactly makes up for
the erosion in purchasing power during the life of the contract. If actual
inflation turns out to be higher than expected, the inflation compensation
turns out too small. Since the creditor is only partially compensated
for the erosion of purchasing power, the debtor gains at his expense.
On the other hand, if actual inflation turns out to be lower than expected,
the inflation compensation more than offsets the erosion of purchasing
power, and the lender gains at the expense of the borrower. Thus, unexpected
inflation transfers wealth between creditors and debtors. Debtors gain
when inflation is unexpectedly high, and creditors gain when it is unexpectedly
Now imagine what would happen if monetary policy were set by majority
vote. Once loans are made, creditors would have a short-term incentive
to vote for policies which would deliver an inflation rate that is lower
than the one implicit in the debt contract, because this would redistribute
wealth in their favor. Similarly, debtors would have a short-term incentive
to vote for policies which would generate an inflation rate that is higher
than the one implicit in the debt contract, because this would redistribute
wealth in their favor. If monetary policy were set by majority vote, the
more numerous faction would prevail.
This raises the question, "are debtors or creditors more numerous?"
Direct evidence on this question is hard to come by, but two observations
suggest that debtors may be more numerous. One follows from typical life-cycle
spending patterns and the fact that the population grows over time. Early
in life, people tend to borrow to invest in education, to smooth consumption
between low income periods in their youth and higher income periods later
in life, and to buy houses and other durable consumption goods. As people
age, they pay off these debts and accumulate wealth for retirement. Thus,
younger people are more likely to be debtors and older people more likely
to be creditors. With population growth, there are more young people than
old, and this suggests that debtors may be more numerous.
This life-cycle consideration is reinforced by the form in which many
people finance their housing purchases. When people take out a mortgage,
they acquire a real asset (land and a house) and a nominal debt (the mortgage).
Like other fixed income securities, a fixed-rate mortgage incorporates
a premium for expected inflation. Since this debt is nominal, its real
value falls if inflation turns out to be higher than expected. Adjustable
rate mortgages also tend to fall in real value when there is an unexpected
increase in inflation, because they usually contain annual and lifetime
caps on the nominal mortgage rate. These caps become especially important
when there are big changes in inflation. On the other side of the balance
sheet, households hold land and houses. Since these are real assets, their
real (or inflation-adjusted) value is much less sensitive to unexpected
changes in inflation. Thus, households who hold nominal debts and real
assets would also benefit from monetary policies which generate surprisingly
If debtors are more numerous than creditors, a majority of voters would
have a short-term incentive to vote for policies which generate an unexpected
increase in inflation. But over a long period of time, inflation cannot
be higher than expected on average. Creditors are not fools. They would
build this knowledge of voting patterns into their inflation forecasts
and mark up the Fisher premium accordingly. Inflation would sometimes
turn out to be higher than expected and sometimes lower, but on average
the majority faction would not be able to use monetary policy to redistribute
wealth. Systematic attempts to do so would just raise the average rate
Moreover, although the majority would prefer low average inflation, they
would not be able to achieve it. When seeking new loans, borrowers would
like to promise to vote for low inflation, but once the contract is signed
they would be free to vote as they please and would again have a short-term
incentive to vote for high inflation. Creditors would see through this
and give their promise little weight. They would insist upon a big Fisher
premium to compensate for high expected inflation, and borrowers would
support a high inflation policy in order to reduce the real value of the
nominal interest rate, thus confirming creditors' expectations of high
inflation. Setting monetary policy by majority vote generates an inflationary
bias which makes everyone worse off. In particular, the majority is worse
off because they suffer the costs of higher inflation without achieving
If everyone prefers low average inflation, why can't the electorate or
the legislature solve the problem by giving the central bank explicit
instructions in the form of official low-inflation targets? Creditors
and debtors both have a long-term incentive to support low inflation,
so both groups would presumably support such a plan. But how would these
targets be enforced? Once debt contracts are signed, borrowers would have
a short-term incentive to support an "exception" to the low
inflation target in order to redistribute wealth in their favor. Hence
the majority's support for low inflation would not be consistent over
time. Their short-term interests for redistribution would undermine their
long-term interests for low average inflation.
The majority needs to find a way to commit to a low-inflation policy.
One way to do so is to delegate authority to an independent committee
and then let them make decisions about monetary policy. In effect, this
makes it more difficult for the majority to change its mind. To achieve
this independence, it may be important to insulate the central bank from
the electorate and their representatives, so that they cannot easily punish
central bankers for rendering decisions that are unpopular in the short
While central bank independence is important, it is not sufficient to
solve this inflationary bias. The composition of the committee is also
important. For example, if this committee were simply a microcosm of the
general population, then majority voting within the committee would just
replicate the inflationary bias in the general population. Thus, it may
also be important to choose committee members so as to balance the forces
for and against inflation. To achieve this balance, it may be necessary
for the anti-inflation forces to be overly represented relative to their
proportion in the general population.
Unexpected inflation redistributes wealth from nominal creditors to nominal
debtors. If debtors are more numerous than creditors, majorities may often
favor monetary policy actions that generate unexpected inflation. But
since monetary policy can't systematically generate surprisingly high
rates of inflation, attempts to use it to redistribute wealth would just
raise the average inflation rate without achieving the intended redistribution.
In the end, policy by majority may lead to outcomes that are inferior
even for the majority, and insulating monetary policy makers from the
electorate may produce superior outcomes.
Alesina, Alberto. 1988. "Macroeconomics and Politics." In NBER
Macroeconomics Annual, Stanley Fischer, ed. Cambridge, MA: MIT Press.
Faust, Jon. 1996. "Whom Can We Trust to Run the Fed? Theoretical
Support for the Founders Views. Journal of Monetary Economics (forthcoming).
Grilli, Vittorio, Donato Masciandaro, and Guido Tabellini. 1991. "Political
and Monetary Institutions and Public Financial Policies in the Industrial
Countries." Economic Policy 13, pp. 341-392.
Tocqueville, Alexis de. 1969. Democracy in America. Garden City, NY:
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco,
or of the Board of Governors of the Federal Reserve System. Editorial
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