The battle for Fed independence: Keeping monetary policy free from harmful influence

Federal Reserve Chair Jerome Powell’s term expires in May. Meanwhile, President Trump is running roughshod over decades of convention with his attempts to influence monetary policy and his verbal abuse of the Fed chair. With the central bank facing a battle for its independence in the months ahead, we set out why independence is important in the first place, how big a threat Trump’s actions are, and how we are responding.

We can trace the origins of many of today’s independent central banks to the high inflation of the 1970s. Academics at the time showed how governments tended to over-inflate their economies, especially around elections, unless they made a credible commitment not to.

For monetary policy (controlling the amount of money and the cost of borrowing) one proposed solution was to delegate decisions to an independent central bank. The theory was that this would insulate policymakers from the political process and short-term incentives, allowing them to make initially unpopular decisions that benefited the economy in the long run. Like the gold standard of the late 1800s and early 1900s, it created a commitment to price stability, but without the unsustainable rigidity of that system.

The theoretical work was followed by empirical evidence: countries with more independent central banks, such as Germany and Switzerland, generally had lower and less volatile inflation in the 1960s, 1970s and 1980s than those with less independent centralbanks, such as Spain, Italy, and the UK.

The emerging academic consensus pushed many countries to increase central bank independence, often complemented by formal inflation targets. New Zealand, where central bank independence had been low and inflation high, is often credited as being the first to take such steps. In 1989 its government granted the Reserve Bank much more autonomy and the single objective of price stability – defined as 0-2% inflation in 1990 – which it met in 1991. Many others followed suit throughout the 1990s (including the UK in 1997). These changes were followed by a period of low and stable inflation in the 2000s and 2010s.

Independence pays off

Countries with more independent central banks had lower and more stable inflation in the 1960s to 1980s, pushing other countries to follow suit.  

The path to independence

The Fed’s path to independence has been more convoluted but still offers lessons about the benefits. During World War II it essentially followed orders from the Treasury Department, holding down interest rates to support the war effort. Unsurprisingly, the Truman administration was reluctant to give up control after the war, and low interest rates ultimately contributed to the high and volatile inflation of the late 1940s. But the Fed eventually won out, reaching an agreement in 1951 that gave it much more freedom, which in turn supported the relative stability over rest of the 1950s and much of the 1960s.

Fed independence came under renewed pressure in the late 1960s when President Lyndon B. Johnson tried to persuade Fed Chair William McChesney Martin to be more accommodative of increased government borrowing. Johnson was unsuccessful but his successor Richard Nixon appointed Arthur Burns as chair. Burns proved more willing to assuage the White House’s desire for lower rates, helping to set the stage for the high inflation of the 1970s. It took President Jimmy Carter appointing the famously hawkish Paul Volcker as chair in 1979 to finally tame it. As a clear global consensus for independent central banks emerged in the decades that followed, Fed independence enjoyed the support of successive presidents, who generally steered clear of commentating on monetary policy matters.

President Trump has now made a clean break with this convention. He has made his desire for lower interest rates clear, attempted to remove Lisa Cook from the Federal Reserve Board of Governors by firing her, appointed Stephen Miran (one of his advisors) to fill a temporary vacancy on the Board, and even reportedly explored firing Jerome Powell.

A limited impact

So far, these efforts to influence the Fed have had little impact. Trump didn’t try to fire Powell in the end. Miran is only one of seven Governors and twelve voting members of the FOMC, the Fed’s monetary policy-setting committee. And while he has attempted to remove Cook, the President’s ability to do so has been challenged in the courts, leaving her in post for now.

But the Fed may come under more political pressure. The Supreme Court will hear oral arguments on January 21 on whether the President has the authority to fire Cook, and it isn’t a foregone conclusion that the court will rule against him. If Cook is fired, that will open another spot on the Board to appoint someone potentially more sympathetic to Trump’s views. He will also be able to pick a new chair from the Board members when Powell’s term as chair ends in May.

Media reports suggest a leading candidate is Kevin Hassett, who is regarded as something of a Trump loyalist and could be appointed to the Board either in place of Miran (whose term ends in January), Cook (if fired), or Powell (who isn’t obliged to resign from the Board when his term as chair ends, but that has been common historically).

As things stand, we think it’s most likely that the Fed will resist these efforts to undermine its independence. To install a sympathetic majority on the Board the President would need to replace (by firing or via voluntary resignations) Cook, Powell, and one more governor. And to get a majority on the FOMC, he would either need to replace at least two more governors on top of that or persuade the Board to fire regional heads that make up the other five FOMC voting members. Trump’s hesitancy to fire Powell and a Supreme Court judgement last year (hinting that it may only support the firings of governors “for cause”) both suggest such aggressive action is unlikely.

The impact of influence

That said, the President is nothing if not unpredictable, so there is still a small risk that Trump might manage to reshape the FOMC with a majority of supporters. Even a signal that Trump is making a more concerted effort to influence the Fed could fuel investors’ fears of political influence, potentially leading to higher US inflation and higher interest rates down the line to counter it. A perceived increase in this risk could prompt a sell-off in longer-term government bonds. After all, we’ve already had one demonstration of this in July amid reports that Trump had drafted a dismissal letter to Powell.

This risk is just one reason why we’re taking a cautious approach to the bonds we choose to include in portfolios – generally preferring those that mature sooner. Indeed, we think this is just another symptom of a broader erosion of central banks’ power to keep inflation low and stable. Not least given growing demands on them to prevent crises erupting in bond markets in the face of continued large-scale borrowing by governments.

This is also why, in many portfolios, we continue to include diversifying assets, such as gold and actively managed strategies – which could perform relatively well when inflation is running high or markets are generally volatile.