Fed Independence: Secure It. Then Use It.

The Fed must remain an independent institution. But it must also act like one.

Source: Wikimedia Commons

Fed Chair Powell announced he will stay on as Governor once his term as Chair expires next month. He’s taking this unprecedented step to protect himself and the independence of the institution. The Department of Justice dropped its criminal investigation. The US Attorney for the District of Columbia, however, pointedly stated she could reopen it. Powell’s decision was the natural response.

In his last FOMC press conference, Powell stated that Fed independence is at risk, as legal threats make it hard to ignore political considerations when setting monetary policy. He expressed confidence in the legal framework, but added that central bank independence does not come from the laws alone, but from the customs that have traditionally defined the boundaries between the Fed and the administration.

Powell was impeccable in his tone and stance. I have praised his style in a previous blog, where I made the point that style is substance.

I agree with him across the board on the points above. Launching a criminal investigation against a sitting Fed Chair was a shocking move, which should have been avoided at all costs. That it came from a U.S. President who uses thuggish threats on a regular basis and was calling for a shift in monetary policy makes it outrageous.

Style and substance

I disagree with Powell, however, on his defense of the Fed’s track record. Powell insists the inflation surge of 2021-23 was entirely due to factors beyond the Fed’s control. Since the Fed kept monetary policy way too loose for way too long even as inflation was taking off, it would be more reassuring to hear they are pondering whether they should have acted differently.

US Bureau of Labor Statistics via FRED

This takes me to my next point. Style is substance, but substance is more than style.

Warsh is being criticized for arguing that faster productivity growth could lower inflation. It’s just a convenient justification for doing what Trump wants him to do, according to his critics. We will see what Warsh does. We do know what Powell did.

The Powell Fed monetized a reckless surge in deficit spending, including 15% of GDP in 2020 and an additional 12% of GDP in 2021 to fund a massive fiscal stimulus package when the U.S. economy was already bouncing back strongly from the COVID recession. Economists of the caliber of Larry Summers immediately pointed out this was unwarranted and would ignite inflation.

Most commentators accept at face value that the Fed was simply doing what it thought was best and not aiming to help a Democratic administration launch a massive expansion of social spending. Biden never threatened the Fed’s independence. But monetization of unnecessary, gigantic deficit spending is not what we expect from an independent central bank. In fact, it makes central bank independence irrelevant.

Powell has stressed repeatedly that the Federal Reserve “exists for one fundamental purpose: foster the economic conditions in which American families and businesses can thrive,” to use his words. I do not doubt the commitment of Fed officials to the welfare of the American people. However, it’s worth reflecting on two considerations.

• First, the structural dovish bias of the Federal Reserve has enabled an inflation surge which drastically eroded the purchasing power of American families.

• Second, the Fed’s compulsive tendency to support financial asset prices has exacerbated wealth inequality.

Headline CPI inflation has exceeded 2% for a full five years now. Since March 2021, monthly year-on-year inflation has averaged 4.5%, and the price of the consumer basket has risen more than double what it would have done with inflation at 2%. (By 25% rather than 10%)

Sources: US Bureau of Labor Statistics via FRED; author’s calculations

The U.S. economy keeps expanding at a solid pace, showing remarkable resilience and powering through shock after shock, as Powell noted. With inflation above target, this suggests monetary policy is not restrictive at all. Yet Powell has again steered the FOMC majority into keeping an easing bias in the latest policy statement.

Hierarchy of concerns

There is a hierarchy of concerns here, in my view.

President Trump’s attacks on the Fed’s independence are by far the gravest one. If legal threats against Fed officials become normalized, the Fed will never be able to act independently. That would be disastrous. A hands-off attitude from the political establishment is a necessary condition for central bank independence.

But it is not sufficient.

Central bank officials need to be willing to take tough decisions, even when these make life harder for the administration. Otherwise, a reliably pliant central bank will encourage politicians to indulge in the profligate fiscal policy to which they are naturally inclined. Which is exactly what’s been happening.

The debate on central bank independence and monetary policy needs to address three pressing threats:

1. Structural inflation pressures

2. Fiscal dominance

3. Financial dominance

Once, globalization gave a downward drift to inflation. Today nationalism, protectionism, and higher geopolitical risks impose upward pressure on prices. Populism and nationalism lead governments to do more and spend more, so fiscal dominance becomes a more pressing concern. And the Fed’s reluctance to disappoint financial markets exacerbates wealth disparities and feeds financial stability risks.

Central bank independence must be protected. But unless we use it to address these three issues, it will not shield us from recurrent bouts of inflation and financial instability.