Kohn Warns Less Fed Autonomy May Cause Higher Rates

Federal Reserve Board Vice Chairman Donald Kohn said any “substantial erosion” of the central bank’s independence in setting interest rates may fuel investor fears of inflation and provoke higher long-term borrowing costs.

“The insulation from short-term political pressures -- within a framework of legislated objectives and accountability and transparency -- that the Congress has established for the Federal Reserve has come to be widely emulated around the world,” Kohn said in testimony prepared for a House Financial Services subcommittee hearing today on Fed independence.

The Fed’s ability to act without political interference is at stake as Congress debates how to overhaul financial regulation following the worst credit crisis since the Great Depression. Some lawmakers advocate congressional audits of the central bank, while others are considering subjecting regional Fed presidents, who vote on interest rates, to Senate approval.

“History provides numerous examples of non-independent central banks being forced to finance large government budget deficits,” Kohn said in a statement. Higher rates may also “further increase the burden of the national debt on current and future generations,” Kohn said.

Kohn didn’t comment in his prepared testimony on the outlook for the economy or monetary policy. The text was posted on the committee’s Web site before the hearing.

The vice chairman said the Fed is now more transparent than at any time since its creation almost a century ago. He cited steps this year to expand information on the Fed’s Web site on its programs and start a monthly report to Congress on the central bank’s emergency lending programs.

Biggest Companies

Many lawmakers oppose an Obama administration proposal to expand the Fed’s powers to oversee the biggest financial companies. The proposal also seeks to curb the Fed’s authority to provide emergency loans to non-bank corporations after the central bank invoked a statute last year to bail out American International Group Inc. and Bear Stearns Cos.

Kohn told lawmakers that the administration’s proposal is a “natural outgrowth” of the Fed’s current regulatory responsibilities and would complement monetary policy.

“I believe that U.S. and foreign experience shows that monetary policy independence and supervisory and regulatory authority are mutually compatible and even have beneficial synergies,” Kohn said. Central banks “bring a broad and unique perspective to analysis” of the financial system, he said.

Approving Audits

Voter concern that the Fed has overstepped its authority has prompted a majority of House lawmakers to co-sponsor a measure allowing for audits by the Government Accountability Office of the central bank’s monetary policy and other operations. Representative Ron Paul of Texas, who introduced the bill, is the senior Republican on the subcommittee.

Such legislation is “contrary to the public interest” because investors may see it as “undermining monetary independence,” Kohn said. “Such an action would increase inflation fears and market interest rates and, ultimately, damage economic stability and job creation.”

A 1978 law prohibits the GAO from peering into Fed activities involving monetary policy or discount-window loans to banks. The GAO also is barred from auditing transactions with foreign governments, central banks and public international financing organizations, Kohn said. The GAO has the power to audit Fed bank-supervision activities and this year gained authority to examine Fed bailouts of companies such as AIG.