The Federal Reserve on Thursday launched a robust defense of its independence and warned that efforts in Congress to put monetary policy under political sway would hurt the economy.

Fed Vice Chairman Donald Kohn said opening up some of the U.S. central bank's most sensitive decisions to political scrutiny could result in higher long-term interest rates and hurt the United States' credit rating.

Testifying before a congressional panel, Kohn sought to beat back a proposed bill that would open the U.S. central bank's policy decisions to audits by a federal watchdog agency. More than half of the members of the U.S. House of Representatives have signed as co-sponsors of the measure.

Any substantial erosion of the Federal Reserve's monetary independence likely would lead to higher long-term interest rates as investors begin to fear future inflation, Kohn told a House subcommittee.

Kohn's testimony comes as Congress debates President Barack Obama's plan for regulatory reform, which envisions the Fed taking on an expanded role monitoring risks across the entire financial system to help ward off future financial crises.

The proposal has boosted calls for greater accountability at the central bank, which already faces heavy scrutiny from lawmakers troubled by its role in bailing out Wall Street.

Kohn said the administration's plan would not greatly expand the Fed's power, and said it would work hand-in-glove with monetary policy, not compromise it as some critics contend.

BACKLASH

Fed officials have had to endure rigorous congressional grillings over their aggressive actions to restore financial calm. Their e-mails have been subpoenaed, recalling past episodes when the central bank came under attack and was forced to yield to the political will.

The proposed bill, put forward by Representative Ron Paul, a Texas Republican and long-standing Fed foe, would expose decisions on monetary policy and emergency lending to audits by the Government Accountability Office.

The GAO is currently prohibited from auditing these areas. Kohn said removing this exclusion would be highly detrimental and could lead investors to worry that politics -- not economics -- would guide the Fed's decisions.

The Federal Reserve strongly believes that removing the statutory limits on GAO audits of monetary policy matters would be contrary to the public interest by tending to undermine the independence and efficacy of monetary policy, Kohn said.

He also said it could cast a chill on monetary policy deliberations by making officials nervous that ideas they discuss behind closed doors could become public.

Paul denied his bill was about Fed independence. We are not looking to the Congress to run monetary policy. We just want to know what's going on, and why, he told Kohn.

However, the bill would remove a provision of law that exempts Fed monetary policy decisions, transactions with other central banks and discussions between Fed officials from GAO audits.

Political attacks on the Fed are not new. Representative Henry Gonzalez pushed hard in the 1990s to force the central bank to publish transcripts of its policy meetings after he exposed that the meetings had been discretely recorded.

Paul's bill has 250 co-sponsors, including 78 Democrats. But it has not been promoted by the Democratic majority leadership in the House, where it has yet to face even a committee-level vote.

If it were to emerge from the House, to become law it would also need to clear the Senate, where support may be scant.

AAA DANGER

Kohn warned that congressional meddling in the Fed's affairs could threaten the United States' AAA credit rating and drive up interest rates.

History provides numerous examples of non-independent central banks being forced to finance large government budget deficits, he said. Such episodes invariably lead to high inflation.

Some investors are already worried the Fed could begin to monetize the debt, and Kohn and St. Louis Federal Reserve Bank President James Bullard said with debt skyrocketing, the Fed's independence had to be fiercely protected.

Any kind of hint that you are trying to take away Fed independence could be very counterproductive at this point in time, Bullard told Bloomberg television.

The Fed cut overnight interest rates almost to zero in December and has pledged to buy up to $1.75 trillion of longer-dated government debt to try to end the worst U.S. recession in decades.

Two other Fed policy-makers also spoke publicly on Thursday.

Minneapolis Federal Reserve Bank President Gary Stern said recovery was close at hand, [ID:nNYS005219] and Fed Governor Elizabeth Duke agreed, though she urged banks to do more to get credit flowing.

Economic conditions are stabilizing or, where they are still deteriorating, appear to be doing so more slowly, she said.

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