Cochrane Is Right About the Fed's Predicament. Here's the Reform Agenda.

Norbert J. Michel and Jai Kedia

In the Washington Post this week, economist John Cochrane laid out the predicament facing Kevin Warsh as he takes over the Federal Reserve: institutional failure on inflation, mounting fiscal pressure, and the prospect of facing the next crisis with an even larger version of the post-pandemic inflation fiasco. Cochrane’s diagnoses are correct, but the question now is what to do about the problems he identified. 

We’re biased, but the Cato Center for Monetary and Financial Alternative’s Reforming the Federal Reserve series offers prescriptive solutions to each problem. The Fed can address virtually all these problems on its own, but in most cases, Congress will have to step in to truly fix the problem. 

Institutional Failure Calls for Structural Fixes 

Cochrane is right that the 2022 inflation was a collective conceptual failure and that Fed forecasts don’t outperform alternatives. The Fed acted on consensus models that proved unreliable, and no obvious replacement forecasting model is waiting on the shelf. Cochrane’s prescription is that the Fed should act with more humility, recognizing the fog it operates in and refraining from acting on forecasts that have proven unreliable. But humility is not an operating procedure, and it has even less practical meaning for a central bank that has become increasingly discretionary. Without a binding framework, the same conceptual gaps that helped entrench post-COVID-19 inflation remain just as dangerous today.

Rules-based monetary policy is the structural alternative. A pre-committed rule substitutes a transparent reaction function for the discretionary forecasting that failed. The FORM Act, which would require the Fed to articulate and explain deviations from a policy rule of its choosing, is the legislative vehicle that already exists for requiring the Fed to follow a policy rule. A Fed that must explain itself against a public benchmark is a Fed that cannot drift as far as the 2021–2022 Fed did before reversing course. This kind of accountability is what matters most, and the choice of rule matters less than the commitment to one.

Balance Sheet Discipline Means a Credible Runway, Not a Sudden Squeeze 

Cochrane warns that squeezing reserves to tighten without raising rates risks repeating the financial chaos of the 1980 credit controls episode. That warning is well taken but only shows why the transition should not be rushed or improvised. A rushed sale of assets risks disrupting financial markets, particularly because it risks banks not having sufficient reserves to meet their lending and operational needs.

The appropriate policy prescription is to publicly commit to shrinking the balance sheet and selling assets over a long period. The cleanest version would be for Congress to set a statutory end date for interest on reserves (IOR) and balance sheet reduction, scheduled for 10 to 15 years, roughly the time it took the Fed to build the balance sheet to its current size.

Without IOR, the Fed cannot maintain reserves far above what banks demand operationally and still maintain any modicum of control on inflation, so a sunset on IOR is effectively a statutory requirement to wind the balance sheet down. Ending IOR returns monetary operations to a framework where reserve scarcity restores the price discipline the federal funds market is supposed to provide and where the Fed is not running a standing fiscal transfer to the banking system. A pre-committed wind-down also constrains future quantitative easing and large-scale asset purchases because a balance sheet headed toward a known smaller end point is harder to expand without explanation.

Fiscal Dominance Is the Case for Binding the Fed in Advance 

Every percentage point of rate increases now adds roughly a percentage point of GDP to the deficit through higher interest costs. This entanglement between monetary and fiscal policy risks unwinding the 1951 Treasury-Fed Accord, returning us to a 1942–1951 type situation where the Fed was conscripted to hold down Treasury yields for fiscal reasons.

The reform that follows is statutory: a binding policy rule paired with explicit limits on the Fed’s ability to purchase Treasury securities outside conventional open-market operations. Binding the Fed to rules-based policy would make monetization harder to rationalize as a response to economic conditions, a particular benefit when fiscal accommodation is a real driver of inflation. 

Separately, Cochrane suggests any bounds on the Fed should be suspended by Congress in genuine crises, citing the 2008 Troubled Asset Relief Program (TARP) precedent. But a binding rule that lifts whenever fiscal pressure is at its highest is not really binding, and the precedents Cochrane cites are precisely the episodes that produced the balance sheet and inflation problems the reform agenda is meant to prevent. If Congress wants to initiate TARP-style spending, it does not need the Fed. 

Conclusion 

The Fed’s role in bank supervision and financial stability has expanded steadily since 2008, and each expansion adds an instrument that can be redirected toward fiscal ends. Capital requirements, liquidity rules, and stress-test parameters can all be calibrated to push regulated institutions toward Treasury holdings. The cleaner structure is to move bank supervision out of the Fed and confine the central bank to monetary policy. That narrows the surface area for political capture and removes the levers that make financial repression feasible.

Many of the Fed’s recent problems can be addressed by binding the Fed to a public rule, with a credible runway to wind down the balance sheet and end IOR. Other improvements would come from setting statutory limits on the Fed’s Treasury purchases and getting the Fed out of the business of regulating banks. If Warsh and Congress are serious about reforming the Fed, they should adopt these policy improvements.

Source: https://www.cato.org/blog/cochrane-right-about-feds-predicament-heres-reform-agenda