Could the Supreme Court Carve Up the Federal Reserve?

Tomorrow, the Supreme Court will hear arguments over whether President Trump can fire Federal Reserve Governor Lisa Cook. The case follows a related one, argued in December, testing whether Congress can shield agency leaders from removal at presidential whim. Most expect the Court to strike down “for cause” removal protections, but some hope the justices will carve out an exception for the Fed. In a 2020 case, the Court’s majority suggested as much, noting that the Federal Reserve’s “monetary functions” might warrant special treatment. The implication was that monetary policy is too consequential for any President to meddle with.

That argument is riddled with problems, but one in particular has received surprisingly little attention: the central bank is responsible for far more than monetary policy. The Federal Reserve regulates and supervises many of the nation’s banks, including the most systemically important ones. It operates much of the payments infrastructure that moves dollars through the economy, and it serves as a lender of last resort in financial crises. Given this sprawling portfolio, some legal scholars and commentators have floated an idea: could the Supreme Court separate the Fed’s monetary policy responsibilities from its regulatory ones? Perhaps the monetary functions could remain insulated while the supervisory apparatus is brought under executive control.

That idea might tempt a Court searching for a limiting principle. But it is also unworkable for a simple reason: monetary policy is bank regulation, and bank regulation is monetary policy, as Fed scholar Lev Menand rightly says. The two cannot be split.

Understanding why requires knowing where money comes from. Most people assume that the money supply is precisely controlled by the central bank. The Federal Reserve prints dollars, and those dollars circulate through the economy. This is true for the paper currency in your wallet, but that physical cash represents only a small fraction of the money supply. The vast majority of money exists as deposits in bank accounts, and those deposits are not created by the Fed. They are created by commercial banks each time they make a loan.

When a bank extends a mortgage or a business line of credit, it does not lend out money that it already has sitting in a vault. Instead, it creates a deposit in the borrower’s account, which is new money, conjured into existence by the act of lending. One Fed economist estimates that 92 percent of the deposits in the American banking system are the result of commercial bank lending decisions. That makes the money supply the aggregate consequence of millions of lending decisions made by thousands of commercial banks each day, not a dial that the Federal Reserve controls directly. When banks lend more, the money supply expands. When they pull back, it contracts. The rate at which banks create money has profound macroeconomic consequences, shaping the pace of economic growth, the level of employment, and the rate of inflation.

The Federal Reserve’s job, when it conducts monetary policy, is to guide these lending decisions. It does so primarily by adjusting the overnight interest rate throughout money markets. When the Fed raises the rate it pays banks on their reserves, borrowing becomes more expensive throughout the economy. Lending slows, and, under normal circumstances, inflationary pressures ease. When the Fed lowers the rate, the opposite happens.

But the overnight interest rate is not the only tool that shapes how much banks lend. Many other regulatory decisions can affect a loan officer’s desire to lend. Capital requirements determine how much equity a bank must hold against its assets. Stricter requirements mean the bank needs more capital to support each new loan, making expansion more costly. Liquidity requirements dictate the minimum amount of quickly sellable assets that a bank must keep on hand, which can constrain its ability to fund long-term lending with short-term deposits. In addition, the specifics of supervisory practices—the day-to-day oversight of bank activities—shape how aggressively banks interpret their risk models and how eagerly they pursue growth. All these regulatory tools affect the collective balance sheet of the banking system. They all influence the rate at which banks create money, making them instruments of monetary policy.

If the Supreme Court were to separate regulatory duties from interest-rate targeting, that could set up a chaotic clash and hurt our ability to guide the economy. Suppose the Federal Reserve is lowering interest rates to stimulate the economy, hoping to encourage more lending. But at the same time, bank supervisors—now under the direction of a President with different priorities—decide to crack down aggressively on lending standards, pursuing examinations that make loan officers reluctant to extend credit. The supervisors might have legitimate concerns about safety and soundness, or they might simply be pursuing a different theory of macroeconomic management. Either way, the result is the same: the monetary stimulus is blunted, perhaps even negated, by the supervisory tightening. The left hand and right hand aren’t coordinating, and confusion reigns.

This is not a hypothetical concern. The history of central banking is littered with examples of regulatory and monetary authorities working at cross purposes. Depression-era caps on interest rates–outside the Fed’s control–meant that tightening monetary policy in the 1960s caused many money market investors to move their money out of regulated bank deposits and into other money-like assets, like Eurodollars and negotiable certificates of deposit. Similarly, in the early 1980s, Savings and Loans (S&Ls) were not primarily supervised by the Federal Reserve. When Chair Paul Volcker led the FOMC to tighten monetary policy dramatically, S&Ls faced an existential squeeze. The long-term fixed-rate mortgages were funded by short-term deposits, and the deposit rate S&Ls could pay was subject to a cap. The body responsible for regulating the S&Ls relaxed capital standards and pursued regulatory forbearance, but it couldn’t help them fundamentally escape their bind. Congress also tried to help by letting S&Ls diversify into higher-yielding investments, hoping they could earn their way out of the hole. They couldn’t, and the result was the S&L crisis and a $120 billion taxpayer bailout.

Splitting the Fed’s functions would recreate the very kinds of coordination problems that the institution was designed to solve. When a single institution controls both monetary policy and bank regulation, coordinated policy can produce more rational and effective policy. A Fed that supervises banks understands how rate increases will transmit through bank balance sheets and can adjust either the rate path or the regulatory environment to avoid unintended consequences. A Fed that sets capital requirements analyzes how those requirements will interact with its interest rate policy to determine the overall availability of credit. The goal is not to subordinate one function to the other, but to ensure that the officials making these decisions are in the same room and accountable for the combined effects of their choices. Unified authority at least makes coherent policy possible.

Nearly all developed economies house monetary and macroprudential regulatory policy in the central bank. The United Kingdom experimented with separating them, placing regulatory policy at the Financial Services Authority in 1997. During the Great Financial Crisis, the separation made it more difficult for authorities to coordinate crisis response, and in 2013 the government rebuilt the system, placing macroprudential regulation under the central bank. Among major economies, Canada stands out for maintaining a relatively clean institutional separation, aided by an unusually concentrated banking system dominated by just six large banks.

Undergirding proposals to split monetary policy from regulation rests an assumption that monetary policy is somehow “technical” and “apolitical,” a matter of scientific management that can, and should, be insulated from democratic pressures. In contrast, bank regulation is supposedly “political” and therefore should be subject to presidential control.

But this distinction does not withstand scrutiny. Monetary policy generally involves distributional choices, and supervision needs to be insulated from political cycles just as much as monetary policy does. A decision to raise interest rates may tame inflation, but it does so by slowing the economy, which can throw people out of work, slow wage growth, and make mortgages, to use just one example, more expensive. A decision to keep rates low may boost employment, but it can also inflate asset prices, enriching those who own stocks and real estate. Supervisory and regulatory functions also involve technical expertise and human judgment, like determining whether a bank’s liquidity buffers are adequate or evaluating the quality of its risk management. To follow Congressional intent and implement regulation effectively, supervisors need to be insulated from the short-term pressures of electoral politics, not prone to having their approach be modified by each change in the occupant of the White House.

The leaders of the Federal Reserve should continue to enjoy “for cause” removal protections. It’s what Congress specified, and it gives the leaders of the central bank the ability to pursue the right decisions, regardless of politics. Every President has the opportunity to appoint a new Fed Chair, ensuring that fundamental leadership at the institution is responsive to democratic demands. For the Supreme Court, the question should not be whether the Fed’s independence can be justified by the distinctiveness of monetary policy. The question is whether the justices understand that nearly everything the Fed does is monetary policy, by another name.