How the Fed's arcane structure could protect monetary policy

  • A pedestrian walks past the Marriner S. Eccles Federal Reserve building in Washington on Dec. 15, 2015.

    A pedestrian walks past the Marriner S. Eccles Federal Reserve building in Washington on Dec. 15, 2015. Bloomberg photo by Andrew Harrer.

Posted10/8/2017 7:17 AM

To the casual observer, the Federal Open Market Committee September meeting in Washington might have looked like any other. But when San Francisco's John Williams, Minneapolis's Neel Kashkari, and the other regional Fed presidents took their seats at the big oval table, an historical anomaly glared back from the other side.

In a rare alignment of events, the five voting presidents outweighed Board of Governors voters, who include Federal Reserve Chair Janet Yellen. It's a gap that opened up earlier this year and which looks poised to persist, at least for the near future.


This matters. There are 12 Fed presidents, chosen for five-year terms by their regional boards. The seven governors are appointed by the president and confirmed by the Senate for staggered 14-year terms. Because of the retirement of Daniel Tarullo, the governor informally tasked with heading financial regulation, the Fed board has been down to four voters since May, and with Vice Chairman Stanley Fischer leaving, it's possible the number could be down to three by the next FOMC meeting.

It looks likely that Randal Quarles, Trump's first nominee, could be confirmed before that, holding the governors steady at four. The regional contingent, meanwhile, remains near full force, with only the Richmond Fed currently looking for a new president.

The Fed's arcane structure, born of populist angst, may protect monetary policy from massive upheaval.

At a time when the current occupant of the Oval Office could choose at least four new governors, the power of the regional presidents amounts to a stabilizing backbone and bastion of independence in an era of transition at the Fed. Yellen, Lael Brainard, and Jerome Powell are the holdouts on the board in Washington, and President Trump isn't expected to reappoint Yellen when her term ends in February.

Thus it could fall to the Fed's arcane system, born of populist angst, to protect monetary policy from massive upheaval. The current state of affairs underscores how this uniquely American setup, erected in stages beginning in the years before World War I, remains relevant a century later, even though many of the functional duties of the world's most powerful central bank have changed.

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"The regional banks are a bizarre set of entities," says Aaron Klein, a Brookings Institution fellow who studies the central bank. "In some ways the mission of the regional system is to bring in diverse viewpoints that challenge the political board."

While two of the board spots seem to be earmarked for fairly conventional picks -- Trump has nominated Quarles, a former investment banker and Department of Treasury official, as financial regulation czar, and Marvin Goodfriend, a professor of economics at Carnegie Mellon University, is being considered for nomination as a governor -- there could be major changes because so many positions remain open.

Fortunately for the Fed, which the world counts on for stability and predictability, its structure means institutional knowledge and independent voters will smooth over any Fed-related tumult in Washington. This is no accident. Some Fed officials like to say that if you built the central bank from scratch today, it'd be done differently.

And yet that assertion is often followed by a rhetorical shrug: It's an odd setup, but it works, so why change it?

Odd it is. The Fed is split into 12 regional branches, each organized like a private corporation, that unevenly divide the country. The San Francisco branch services a third of the nation, for instance, while Missouri hosts two branches, one in Kansas City and another in St. Louis. Even this patchwork quilt of a system wasn't knitted until 1913. Before that, public distrust of big government and East Coast financiers-think farmers vs. bankers-doomed two earlier efforts to create a permanent U.S. central bank.


In early September, Minneapolis Fed President Kashkari happened to describe why the 20-year charter of the First Bank of the United States was allowed to expire in 1811: "A bunch of bankers in a dark room doing God knows what? It just did not sound very American, and so they got rid of it."

The current decentralized system, created with an eye on representing a diverse set of national interests, was explicitly crafted to reduce the danger of control by Washington or capture by Wall Street. In 1914, Treasury Secretary William McAdoo sat on the committee that picked the 12 locations, which were chosen partly because of their importance to banking at the time. Each regional board selects its own president, five of whom vote in any given year (the New York Fed is one, and while others rotate, it has a permanent vote). Overseeing them from Washington is the board of seven governors. Unlike the bank presidents, governors vote on all FOMC matters.

Members of the Board of Governors are historically slightly more dovish on monetary policy than the regional presidents, possibly because they're less eager to take away the punchbowl when economic growth is heating up (and, not incidentally, pleasing the constituents of the politicians who installed the governors in the first place). Because governors vote in every instance, and in greater numbers, the board has traditionally enjoyed more power than the regional branches.

The balance of power has shifted in recent years, however. The regional banks have become increasingly vocal when it comes to monetary policy, especially starting when Ben Bernanke took over at the Fed in 2006, a year before the onset of the Great Recession. As Main Street blamed Wall Street for the financial crisis, Bernanke made policymaking transparency a priority, and discussion blossomed on a public stage.

Under Bernanke, the governors voted in near-unbroken harmony. As the central bank made unprecedented bond purchases and navigated the longest low-rate period in its history, no governor ever officially disagreed. The last dissent actually came just after Hurricane Katrina in 2005, when Mark Olson wanted to put off key policy decisions until after the storm's economic impact could be fully assessed. Regional banks, by contrast, have cast 68 protest votes under Bernanke and Yellen. "It was a controversial and difficult period, which should have generated more dissents than usual, and it didn't among the governors," says Charles Plosser, former head of the Philadelphia Fed and a frequent dissenter.

While the divergence between governors and regional presidents illustrates how the banks that run branches can serve as a moderating force and a challenging voice against the board, all those "no" votes weren't created equal. Some presidents dissented so often that their disagreement came to be discounted-noise that did little to change the outcome.

That's not to say dissent doesn't matter. On a number of occasions -- such as in September 2016, when Boston Fed President Eric Rosengren, a relative centrist, joined Cleveland's Loretta Mester and Kansas City's Esther George in voting against holding interest rates steady -- votes against the mainstream have signaled a genuine shift in sentiment. The dissent that September was followed by a rate increase in December.

In an era when populism pervades politics and Washington is so out of favor, the branch banks serve a secondary purpose: They give at least the impression that the Fed, seen by many as aloof and esoteric, is in touch with the American people. Regional presidents make regular appearances at chambers of commerce, Rotary Clubs, and other community organizations across the land.

"Almost in any human activity, where you sit does have some influence on where you stand, so you get a perspective on your part of the country," says Dennis Lockhart, former president of the Atlanta Fed. "That's worthwhile input-otherwise the bubble of Washington would be what dictates monetary policy."

Yellen has spoken of the merits of this kind of grounding. Earlier this year she told a story about how, when she was president of the San Francisco Fed in 2007, her conversations with local business leaders helped her to see the housing bubble coming. Of course, by 2007 any warnings about the subprime mortgage crisis were too little, too late-a realization that has since led regional Fed research departments to recruit more specialists.

"There were holes revealed in the crisis and aftermath," says Narayana Kocherlakota, who was Minneapolis Fed president from 2009 through 2015 and is a Bloomberg View contributor. "Speaking for Minneapolis, we were certainly wrong-footed. We didn't have the kind of people in the labor markets or financial markets that we needed."

If there's one place where the regional banks can't provide much of a moderating influence, it's regulation. As quasi-private bodies, regional Feds don't vote on rules governing banking; that's the exclusive purview of the Fed board. But the branches supervise banks in their districts, and until the financial crisis they had discretion in implementing regulations and enforcing them.

The crash and the rise of Tarullo as the Fed's post-crisis finance czar changed that. Tarullo pulled regulatory authority back to Washington and away from regional examiners, especially those at the New York Fed who'd been tasked with overseeing the largest financial institutions. "It had gotten a bit diffuse-more diffuse than seemed like the right thing to do," says Nellie Liang, who was director for financial stability policy and research at the Fed until this year.

Now much of the power Tarullo wielded will shift to his likely successor. Quarles, who got the Senate Banking Committee's nod in September and awaits confirmation by the full Senate, is expected to be more bank-friendly than his predecessor without marking a radical departure. "He's not a 'let's take a torch to the place' kind of guy," says Ian Katz, an analyst at Capital Alpha Partners.

While the Fed's structure might insulate the institution from upheaval, it has its flaws. One frequent criticism of the quasi-private structure is that it isn't transparent. Because the banks aren't taxpayer-funded public institutions, they take the position that they're not legally subject to Freedom of Information Act requests, though they say they follow FOIA in spirit. Another complaint centers on regional bank president selection, which takes place largely behind closed doors.

The regional boards choose a candidate and send the name to the Board of Governors in Washington for approval. The slate of contenders from which the candidate emerged is never made public. This can create a public appearance problem, as it did when then-University of Delaware President Patrick Harker led the hunt for a new president of the Philadelphia Fed; the search committee ultimately selected Harker.

The selection process came under even more intense scrutiny when Richmond Fed President Jeffrey Lacker disclosed in April that he'd inadvertently confirmed leaked FOMC information to an analyst at Medley Global Advisors, an economic research firm, in 2012. Lacker was reappointed in 2015 but ultimately resigned in April 2017 over his involvement in the leak. That suggests he either wasn't being watched closely enough or that his regional board knew and chose to look the other way.

"Who is responsible for this, and when things are going wrong, how do we hold them to account?" asks Peter Conti-Brown, a Fed historian at the University of Pennsylvania. The Fed's internal governance, he adds, "is not working in a very effective way."

Lack of accountability at the regional banks extends to the White House: The Fed presidents are in no way beholden to the president. That could prove important, because it means that even if Trump picked new Fed leaders with a history of loyalty-such as Gary Cohn, one of his top advisers and a frequent favorite on short lists of possible Yellen successors-the Fed remains in the hands of independent actors.

What's more, the apolitical nature of the process makes regional presidencies relatively easy to fill even in an era of partisan strife. That means that if the appointments of governors drag on-as the sluggish progress of the Quarles nomination suggests they will-the committee will retain a base of seasoned voters. "There will be a lot of change at the highest level of the Fed in the next 12 months, for sure," says Carl Tannenbaum, chief economist at Northern Trust Corp. and a former Fed economist. "I'm not overly worried. 'Curious' is the better word-as we all are."

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