A crash course in Fed independence

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With recession odds rising and the stock market down, it is no surprise that President Trump thinks the Fed's ‘wait-and-see’ approach to rate cuts is a mistake. And there’s some chance he’s right. But, under the current norms of monetary policy, such criticisms from the President are normally kept out of the public eye. Trump took it further last week and said, “Powell’s termination cannot come fast enough.” That triggered another news cycle about whether Trump could remove Powell and, if he did, what would happen. Monday, Trump reiterated the call for the Fed to cut rates. Financial markets have reacted poorly to the attacks on the Fed’s independence. Tuesday afternoon, the President said he had “no intention” to fire Powell, calling a truce for now. This week has been a crash course in why Fed independence matters.

I talked on Bloomberg TV Monday about Fed independence. You can listen here or watch here. Today’s post shares and expands on some of my comments.

Will Trump fire Powell?

There is a risk that President Trump will try to remove Powell as Fed Chair, even though he has no intention now. We cannot say it’s “unthinkable” or use Trump’s first term as a guide when similar threats did not turn into action. Many considered pushing the effective tariff rate to its highest level in over a hundred years unthinkable, but that’s what we have now.

Last week, Kevin Hassett, a top economic official at the White House, said they “will continue to study” options to remove Powell. I am convinced that any careful study of Fed independence would lead the administration to the correct decision to keep Powell and stop pressuring the Fed to lower rates. Setting aside the turmoil in financial markets that would ensue if Trump fired Powell (interest rates would go up, not down, on fears of inflation and instability), removing Powell would undercut the credibility of any future Chair that the President appoints and risk persistently higher inflation. Damage would be done, regardless of how the Supreme Court rules on the legality.

There is a case for pre-emptive rate cuts now, but the President should not be the one making it. Threatening to remove the Fed Chair creates more uncertainty at a time when uncertainty is already unusually high. This would be an excellent time for the President to de-escalate and stop pressuring the Fed. Otherwise, tensions will likely build, and we could see a very bad day of economic data later this year, which will turn into a historically bad day with Trump firing Powell. It’s best to get off that path now.

Why should the Fed be independent?

To fulfill its dual mandate of maximum employment and stable prices, the Fed should be as independent from political influence as possible, and it must also be accountable to the American people. Congress created the Federal Reserve in 1913 and has repeatedly amended the act. Monetary policy is one of several functions of the Fed, and there is variation in the degree of operational autonomy. Regarding accountability, the Fed must report to Congress regularly and explain its actions to the public. There are times when the Fed has used tools, such as emergency lending in the Global Financial Crisis in 2008, that Congress later decided to place restrictions on. Now, emergency lending facilities require approval from the Treasury.

The ability of the Fed to independently set interest rates has evolved. Originally, the Secretary of the Treasury and the Comptroller of the Currency were on the Fed’s board until 1935, when the seven Governor positions (President appointed, Senate confirmed) were created. During World War II, the Fed agreed to keep the government’s borrowing costs low to help finance the war effort. However, inflation rose after the war, with rates low, so the Treasury-Federal Reserve Accord of 1951 allowed the Fed to set interest rates independently. After the high inflation of the 1970s in the US and worldwide, the conclusion was that central banks with discretion over monetary policy are crucial to keeping inflation low and stable. In a speech in 2010, then Fed Chair Ben Bernanke explained the reasons:

In contrast, policymakers in a central bank subject to short-term political influence may face pressures to overstimulate the economy to achieve short-term output and employment gains that exceed the economy's underlying potential. Such gains may be popular at first, and thus helpful in an election campaign, but they are not sustainable and soon evaporate, leaving behind only inflationary pressures that worsen the economy's longer-term prospects. Thus, political interference in monetary policy can generate undesirable boom-bust cycles that ultimately lead to both a less stable economy and higher inflation.

The boom-bust cycles are not the worst of it. It could boost inflation persistently:

Central banks regularly commit to maintain low inflation in the longer term; if such a promise is viewed as credible by the public, then it will tend to be self-fulfilling, as inflation expectations will be low and households and firms will temper their demands for higher wages and prices. However, a central bank subject to short-term political influences would likely not be credible when it promised low inflation, as the public would recognize the risk that monetary policymakers could be pressured to pursue short-run expansionary policies that would be inconsistent with long-run price stability. When the central bank is not credible, the public will expect high inflation and, accordingly, demand more-rapid increases in nominal wages and in prices. Thus, lack of independence of the central bank can lead to higher inflation and inflation expectations in the longer run, with no offsetting benefits in terms of greater output or employment.

Fed independence exists for a moment like this. Higher tariffs from the administration are likely to lower growth and boost inflation this year, which could put the dual mandate in tension. While tariffs would typically cause a temporary rise in inflation, as the tariffs lead to a one-time rise in the price level, there is a risk that they lead to a more persistent boost to inflation and higher inflation expectations. As Powell discussed in Chicago last week, the Fed wants to see more of the effects of the tariffs before adjusting interest rates. Those remarks are what kicked off President Trump’s reaction. Trump is not the first President to prefer lower interest rates. It’s a common tension between the White House and the Fed. Independence for the Fed on monetary policy is considered the best way to deal with that tension.

The Fed faces complicated decisions this year. It will be extremely difficult to sort through the economic data, given the large increase in tariffs, reduced immigration, and government downsizing, and make forecasts with any degree of confidence. If the President politicizes the Fed, it will be even harder. Powell and others at the Fed said they will put their heads down and do their job. Here is Powell in Chicago:

We’re never going to be influenced by any political pressure. People can say whatever they want, that’s fine. That’s not a problem. But we will do what we do strictly without consideration of political or any other extraneous factors.

The credibility of the Fed rests on both the reality and the appearance of non-partisanship. The criticisms from the President could alter public perceptions about the Fed. When the Fed cut its federal funds rate (a short-term rate for banks), if enough people believe it caved to the President, that would reduce the credibility of the Fed in fighting inflation, leading to higher inflation expectations built into market prices and people’s behavior. Longer-term interest rates, such as 10-year Treasuries and 30-year mortgage rates, could increase, even if the federal funds rate decreases to compensate for the higher expected inflation.

Criticism of the Fed’s actions is normal and necessary, but it is not helpful if that criticism comes from the White House. Powell mentions ‘the professional commentators’ often. Fed officials consider alternative views. They know that the Fed’s independence, even the Fed’s existence, rests on the quality of their decisions. When the criticism comes from the President, it could be viewed as political influence.

So what’s coming next in markets and from the Fed?

Will interest rates such as the 10- and 30-year Treasury rates fall because we are heading into a severe recession? Will they rise due to larger budget deficits, more uncertainty, or higher inflation expectations? Anything is possible, and that’s part of the problem. The changes in economic policy—above all, tariffs—make it especially hard for anyone to predict the economic future. That’s exactly what financial markets try to do. We will likely see a lot of volatility.

The President has unique levers to reduce uncertainty if he chooses. Taking the removal of the Fed Chair off the table would be a start. His remarks on Tuesday that he has no intention of firing Powell were a step in that direction. Next, the President should say he has “no legal authority” to remove Powell and stop commenting on monetary policy. Clarifying his trade policies is also essential. Of course, reduced uncertainty only goes so far. The details of the trade, immigration, fiscal, and regulatory policies will matter most.

What’s the lesson for the Fed from the past week? I initially thought Powell should say less in public. His remarks in Chicago, such as “the effects of tariffs will include higher inflation and slower growth,” and his repeated assertion that the Fed was in no hurry to cut rates and that he could not be removed, were guaranteed to annoy Trump. Powell did not say anything materially new, but his tariff discussion was more negative. Was it worth a news cycle about Trump possibly firing Powell? Probably. Silence from the Fed is not the answer. Transparency is necessary for accountability, and accountability is necessary for independence. Powell and the rest of the Fed must continue to explain their thinking and back it up with data and research. They should keep doing business as usual, recognizing that this moment is anything but usual.

In closing.

Powell ended his speech in Chicago last week, noting that “life moves pretty fast,” a reference to Ferris Bueller, and it has been a fast-moving week on Fed independence since then. The ability of the Fed to make decisions independent of politics on monetary policy is grounded in the law, relies on established norms, and is justified by past experiences with inflation. It’s not a perfect solution, but it’s better than the alternatives.