Independence
The Fed remains free as a dove
Should we be concerned about central bank independence? As a general proposition, certainly yes. Whether you’re a businessman or entrepreneur, a consumer or even an economist…you should care about central bank independence. Central bank independence is a good thing. Countries with independent central banks generally enjoy lower inflation and stronger economic growth.
Should we worry about central bank independence in the US today? That very much depends. It depends on what you’re afraid of, and what you think independence means.
Before you shoot me (metaphorically), let me explain.
President Trump’s attacks on the Federal Reserve and on Fed Chair Jay Powell are unjustified, unseemly, and unhelpful. With characteristic disregard for established norms and institutions, Trump has expressed an unhealthy desire to be consulted on monetary policy decisions, and has even threatened to fire Powell — contributing to a rather hysterical media kerfuffle this week.
The thing is, he cannot do that. The law won’t allow it — and you’ll agree with me that there is no shortage of judges ready to jump in.
The Fed’s independence is protected by law under the Federal Reserve Act. The law grants the Fed instrument independence: this means that while Congress sets the Fed’s goals (maximum employment and price stability), the Fed enjoys full independence in setting its instruments (interest rates, size of balance sheet) in order to meet those goals, without political interference. The President cannot fire the Fed Chair — except for narrowly defined cause. And the President cannot demand to be involved in monetary policy decisions.
How strong is this legal safeguard? The Fed is accountable to Congress, and Congress has the power to amend or repeal the Federal Reserve Act with a simple majority vote. This might sound like a low bar. However, repealing the Federal Reserve Act would be a hugely momentous decision; the impact on financial markets would be unpredictable and likely catastrophic. It’s extremely unlikely that Congress would take such a decision lightly — in fact it’s not even remotely on the table. Keep in mind that even for tariffs President Trump is proceeding via executive order rather than betting on Congress’ support.
Trump has insinuated that Powell might be removed for cause if found guilty of fraud tied to cost overruns on a renovation project at the Fed building. Recourse to such a banana republic escamotage would almost certainly fail in the courts, but would still do immense damage to US credibility — even though a $2.5 billion cost tag for a renovation does raise some eyebrows, especially for a loss-making government institution. Attempting it just to get Powell out of office a few months ahead of schedule would be ludicrously irresponsible, and I see it as extremely unlikely.
Powell’s term runs through May next year. The traditional transition period is three to four months, so a successor would normally be picked by January-February (I think we can take it for granted that Powell will not be offered a third term). Rumors from the traditional “people familiar with the matter” indicate that Trump might decide to nominate a successor earlier, by September-October or even before that. The fear is that the nominee could then try to influence market expectations by voicing his views on the desirable path of monetary policy.
Trump might well announce a successor early to further delegitimize Powell — our current President takes delight in dishing out personal slights and humiliations. But that in itself would have only a marginal impact, in my view. And it’s very unlikely that the nominee would promptly start to voice his views on monetary policy in obeisance to Trump. Anybody willing to act as such a political stooge would lose credibility with the Federal Open Market Committee, the Fed’s decision-making body, and lose the ability to guide the collective policy-setting process — monetary policy decisions require a majority of the twelve voting FOMC members. This would probably not be an issue anyway, because such a political stooge would most likely not win Senate confirmation. (The Chair and Vice Chair of the Fed, as well as the Vice Chair for Supervision and the seven members of the Board of Governors, are nominated by the President and confirmed by the Senate.)
Are you worried that the Fed might lower interest rates and expand the balance sheet to monetize an irresponsible fiscal policy? Been there, done that, got the high-inflation t-shirt.
But what about the risk that the next Fed Chair, while following protocol, might lend a much friendlier ear to Trump’s calls for lower interest rates?
Ah. So, are you worried about the prospect of a dovish Fed? Because that ship sailed a long time ago. The Fed has always had a strong dovish bias, with the notable exception of the Volcker period. Are you worried that the Fed might lower interest rates and expand the balance sheet to monetize an irresponsible fiscal policy? Been there, done that, got the high-inflation t-shirt. Jay Powell monetized the Trump-Biden pandemic blowout, and held interest rates at zero while inflation surged towards double-digits. Yes, of course it was an emergency situation, but these days everything gets labeled an emergency, from climate to social issue to geopolitical tremors.
We’re talking about the Fed that kept monetary policy exceptionally loose for a full fifteen years following the Global Financial Crisis. The Fed whose perennially accommodating monetary stance in fact enabled the Global Financial Crisis and various asset bubbles. The same Fed that couldn’t wait to start cutting rates again last September. Is it that kind of dovish Fed you’re worried about? Because we’ve got it already. And almost everyone seemed to be happy with it, especially in financial markets. Even now, most financial market participants seem most concerned that the Fed will not cut rates soon enough and deep enough.
I worry a lot more about fiscal policy. And, as I’ve written before, I’m happy that my concern is much more widely shared now that we can blame Trump for the unsustainable fiscal path we’re on. Deficit addiction and rising public debt create a fiscal dominance effect that makes the Fed’s job a lot harder. They increase the temptation to tolerate further bursts of high inflation to help limit debt growth with a hidden tax on our purchasing power — as the post-Covid inflation did. And further inflation episodes would erode the Fed’s credibility and undermine investors’ confidence in the dollar.
My guess is that Trump is just preemptively shifting the blame on the Fed in case his own policies tip us into a slowdown. That’s the best he can do and it’s all he needs to do.
Formal central bank independence is precious and should be preserved. But that’s not where the biggest risk to sound monetary policy comes from now. Let’s keep our eye on the ball.
Thanks, Marco, for sharing your thoughts. Yes, there is a lot of concern about Central Banks' independence in this period, but as I have been thinking more about this, the other side of the coin is accountability. The testimonies at the Congress and publishing minutes and communication more broadly partly address this issue from my point of view. Should we hold Central Bankers to their ability to fulfill their mandate? Over which horizon? What are the consequences if they fail? The so-called Great Moderation has given the impression that Central Banks are powerful in achieving their inflation objective, but I would say that the post-Global Financial Crisis period and the post-pandemic developments are seriously questioning that view and, more broadly, the role of Central Banks.
Politely disagree. I think the Fed’s independence is now seriously at risk. One reason is that if the Trump administration manages to control the Fed, it opens vast new pastures for rent seeking (using a polite term).
On the Fed’s Covid era performance, I am much less critical than Marco (and others). I interpret the initial phase of Covid as a large negative supply shock that lowered activity and created inflationary pressures. The Fed could have counteracted those inflationary pressures by raising interest rates and QT starting in 2021, but adding a negative demand shock to a negative supply shock is usually not good practice for a central bank with a dual mandate. In any case, the negative supply shock reversed itself while fiscal policy was highly expansionary. The Fed duly started counteracting by raising interest rates and some QT. The end result was a temporary inflation burst (that lowered the public debt-GDP ratio by some 10 percent of GDP), while the real economy was back at equilibrium. It’s best to trace out this macro shock story in a standard AD-AS diagram. 😊 And that might also help understand why the temporary US inflation experience was common across almost all industrial countries independently of their specific fiscal and monetary policies (with Switzerland, as always, the exception). All of this doesn’t mean that one cannot critique central banks for being overly attentive to the wellbeing of the financial sector.