A report from The Manhattan Institute titled Reform the Federal Reserve’s Governance to Deliver Better Monetary Outcomes critiques the Fed's current structure, which allegedly limits its effectiveness. Dan Katz, Manhattan Institute adjunct fellow and former Treasury Department senior advisor, co-authored the report. He joins Yahoo Finance to discuss how the Fed's influence extends beyond monetary policy, outlining possible structural reforms.

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Editor's note: This article was written by Nicholas Jacobino

Video Transcript

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JULIE HYMAN: The Federal Reserve's March meeting kicks off in less than a week. And investors will listen closely for any indication of timing on upcoming rate cuts. The central bank since its founding more than 100 years ago has seen its impact extend beyond just monetary policy. And that according to our next guest is a problem.

Dan Katz of Manhattan Institute adjunct fellow and former Treasury Department senior advisor argues in a new report that the Fed's current structure limits its effectiveness and some significant reforms are necessary. And Dan Katz is joining us now. Thanks for being here, Dan.

- It's great to be with you.

JULIE HYMAN: So first of all, what is the problem with the Fed, as succinctly and sort of in as plain language as you can? And is it just outside the bounds of its traditional role in monetary policy?

DAN KATZ: Well, the problem with the Fed that most people, as most people understand it, is that we've actually had very bad monetary policy in recent years. And that's contributed to the inflation that we've had recently. And so what we've tried to do in our report is to step back and say, look, the Fed is this very special institution. That's not like any other government agency. It really has very limited accountability, because we're trying to insulate it from politics in the tradition of central bank independence.

And so what my co-author Steve Myron and I did is we looked at the Fed's governance. And we asked ourselves, what is it about the Fed's governance that contributed to the mistakes of the last few years? And are there any adjustments we should to make the Fed perform better? And what we've found is that the Fed's lack of accountability really did contribute to many of the monetary policy errors of recent years.

So the structure of the rate-setting FOMC is dominated by the DC-based Board of Governors. And that has really enabled groupthink that has allowed the Fed, for example, to unilaterally reinterpret its inflation mandate in 2020 to purposefully try to overshoot its inflation target and then, for the next year and a half, to dismiss inflation as transitory, which, of course, contributed to the inflation that resulted in declining real incomes in recent years. Additionally--

JULIE HYMAN: So--

DAN KATZ: Sorry, go ahead.

JULIE HYMAN: Please, go ahead.

DAN KATZ: Well, you know, and beyond monetary policy the Fed's wider responsibilities have also dragged it into the political arena. Think banking regulation and crisis response. And so what we recommend in our report is a set of solutions to change the Fed's governance arrangement that we believe could help insulate the monetary policy process from political pressure and result in better monetary policy over time.

JULIE HYMAN: Well, it sounds-- it sounds like part of what you're arguing is not necessarily political pressure, it's more just the structure of the Fed internally. So for example, when you talk about groupthink, that's not necessarily a political problem, that's just a sort of a human problem, right? So how would you correct for something like that?

DAN KATZ: Yeah. So that's exactly right it's really about the incentives on the FOMC and what that does for the monetary policy process. And I think it's important to recognize that central bank independence does not just mean an absence of accountability. Accountability is a fundamental mechanism we use across society to ensure good performance. This is fundamental to corporate governance, for example.

And we really believe if you want to incentivize the Fed to do better next time around, you need to inject more accountability into the process and you also need to change the structure of the Fed to reduce the incentives for, for example, groupthink and to reduce its responsibilities that are so tightly bound up in the political process that they result in the Fed being politicized.

Like, for example, the current fight around bank regulation and the so-called Basel III Endgame, which has the Fed deeply enmeshed in a very, very ugly political fight in DC, which is really not helpful for the Fed to be able to conduct monetary policy independent moving forward.

JULIE HYMAN: So I just want to focus more on the monetary policy side of things. How do you incentivize-- well, I guess, first of all, how do you incentivize better decision-making? And who decides whether the decision-making is good or bad? Frequently, that kind of thing is not obvious to say the least until it's too late or until later, right? I mean, in other words, you have a lot of arguing in real time about whether the Fed's decision making is correct or not, external arguing, that is. So how do you decide if it's right or not? And then how do you incentivize the, quote unquote, "right decision?"

DAN KATZ: Sure. So obviously, no system is going to be perfect. That is the nature of dealing with uncertainty, which is an inherent feature of the economy. And so adopting, for example, a policy rule like a Taylor rule or curtailing the Fed's scope of action ex-ante, we think would actually be a very big mistake, because you do need real people in the room debating ideas and trying to make the best of an uncertain future.

What we focus on in the report is trying to create better incentives for decision making on the Fed by relying on checks and balances and also by injecting additional accountability. So for example, on the Board of Governors, what we're calling on is for a restructuring of the terms of governors to shorten their terms, to also impose cooling off periods before returning to service in the executive branch to reduce the incentives for politicized decision-making, and also to allow the president to remove Fed governors for poor performance.

And we would balance this increased presidential control over the Board of Governors with a revamped reserve bank system. So right now the reserve banks basically lack complete democratic legitimacy. They're actually private corporations that are largely governed by local special interests. And so what we would do is bring them into the government formally. And we would have their leadership selected by the states in their district. And crucially, on the FOMC, we would have all the reserve banks vote at every meeting.

So the idea is you balance a board of governors that's under increased presidential control with a revamped reserve bank system that is more accountable at the state level to create a check and balance throughout the system to avoid politicized decision making on the FOMC. That's not going to be perfect, but we think that it increased diversity of voices on the FOMC is going to help lead to better decision making over time.

JULIE HYMAN: Dan, it's very thought-provoking. And I appreciate you coming on and sharing it with us.

DAN KATZ: Thanks for having me. Great to be with you.

JULIE HYMAN: Thanks.