As the Obama administration continues to shape the regulatory overhaul that is being conducted as a result of the financial crisis, one oversight measure that appears to have gained some support across party lines is giving the General Accounting Office broader authority to examine the Federal Reserve's conduct of monetary policy. Of all of the actions that have been proposed in the aftermath of this crisis, decreasing the independence of the Federal Reserve by increasing congressional oversight is perhaps the one that has the potential to be most damaging to the long term health of the U.S. economy.

Contrary to popular perception, it is the Federal Reserve rather than the President that exerts the most powerful direct influence on the direction of the U.S. economy. While a President can propose policies and tax changes (which must then be approved by Congress), it is the Federal Reserve that controls the money supply and exerts influence on interest rates throughout the entire economy with no input from Congress or the President being required. The Fed uses monetary policy to try and fulfill two of its major goals which are to promote full employment and maintain price stability (i.e. mitigate inflation). Unfortunately, any action that the Fed takes to control one has the effect of exacerbating the other. For example, the Fed’s response to the current crisis has been to flood the U.S. economy with dollars (i.e increasing the money supply) in an effort to get the economy going again (and thereby increase employment). However, actions of this sort tend to increase inflationary pressures. At some point in time, it is likely that the Fed will have to begin contracting the money supply to combat inflation.

Given that the Fed must walk this tightrope, it is imperative that the Fed not be subjected to the political pressures that increased congressional oversight would likely bring. The power that the Fed exerts over the economy means that politicians will necessarily attempt to use their power to shape Fed policy actions in a way that the politicians believe will enhance their electoral prospects, rather than what is necessarily best for the long-term health of the economy as a whole. The potential for congressional meddling will inject another element of uncertainty into financial markets and business decisions as investors will need to engage in political calculations (along with the normal economic analysis) when making an investment/business decision based on macroeconomic factors. This additional uncertainty will likely lead to higher interest rates than would otherwise be the case as investors demand compensation for the additional risk, which will likely have the effect of lessening economic growth over the long run.

While there is no doubt that policy mistakes by the Fed (i.e. keeping monetary policy too loose for too long) helped to fuel the real estate bubble and contributed to the ensuing crisis, these mistakes were made while the Fed was trying to do the best job that it could in fulfilling its mandate. The idea that increased congressional oversight would improve monetary policy is doubtful at best. Federal Reserve independence is too important to be tossed aside in the political turmoil of a crisis period that will eventually pass. Increasing congressional oversight of the Fed is an idea that should be scrapped.