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What if Fed loses its autonomy?

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According to economists, a President making policy decisions for the Federal Reserve would most likely result in higher inflation

A long-running controversy over who should lead the United States Federal Reserve erupted in April 2024 after The Wall Street Journal revealed that some in the inner circle of Donald Trump (Republic Party’s nominee for the Presidential Elections 2024) had discussed putting more authority over the central bank, a key institution in managing the nation’s economy.

According to economists, a President making policy decisions for the Federal Reserve would most likely result in higher inflation. The Fed would probably come under pressure from most presidents to maintain its benchmark interest rate lower than it otherwise would, increasing inflation.

James Bullard, a former president of the Federal Reserve Bank of St. Louis and member of the Fed’s policy committee from 2008 to 2023, said, “The data is quite clear that you’re going to get greater and more volatile inflation eventually if you give up an independent central bank.”

The “stagflation” era served as a warning, according to Sarah Binder, a political science professor at Georgetown University and an authority on how politicians affect the Fed. She added that presidents Richard Nixon and Lyndon Johnson put pressure on the Federal Reserve to cut interest rates, which contributed to the double-digit inflation and economic stagnation of the 1970s.

She told Investopedia, “The past of the 1970s demonstrates that such type of political pressure contributed to releasing inflation for nearly a decade. While it’s not a given that the Fed will submit to Trump’s demands, it does put the Fed in a very vulnerable political position.”

The independence of the Fed

The Federal Reserve is a unique branch of the American government since it is intended to be somewhat immune to political influence.

A series of bank failures led to the Fed’s establishment in 1913 to stabilize the financial system. Over time, the central bank’s authority increased. These days, its duties include overseeing banks and, most importantly, determining the monetary policy of the world’s largest democracy.

In 1977, Congress gave the Fed a twin mandate: maintain full employment in the economy while controlling inflation. It primarily accomplishes this by influencing the fed funds rate, which establishes the interest rate at which banks in the country lend money to one another. This affects interest rates on a wide range of other loans across the economy, including personal and corporate loans like mortgages.

A committee consisting of a rotating group of one-year regional bank presidents and presidential appointees with 14-year tenure decides whether to raise or cut interest rates.

The Federal Open Market Committee (FOMC) is freer than other federal agencies to function as technocrats and make decisions based on what they believe to be sensible economic policy rather than political considerations because the president can only appoint a small number of FOMC members during any given term in office—at least in theory.

The goal of the Fed’s detractors has always been to give the other arms of government more authority over the central bank. They frequently contend that because of the Fed’s independence, the public cannot hold it accountable, rendering its governance undemocratic. The Fed’s economists have also come under fire for being unelected bureaucrats and for being ineligible to decide on matters of economic policy.

Should Fed be politicised?

The Fed has gained a lot of attention due to its gradual hike in the fed funds rate, which it used to control inflation that had grown well beyond its objective of 2%. Currently, the benchmark rate range has been at a 23-year high of 5.25%–5.50% since July 2023.

Because of the restrictive monetary policy’s contribution to lower inflation, investors and consumers now have hope that interest rate reductions are imminent. But before loosening policy, Fed policymakers have stated that they need further assurance that pricing pressures are under control.

Economists caution that a Fed under the president’s direction is more likely to allow inflation to spiral out of control.

According to Victor Li, a Villanova economics professor, presidents have every right to encourage the Fed to cut interest rates and have done so in the past, in part because election cycles force them to look short-term.

A president should be proud of the fact that the economy grows, the Fed lowers interest rates, loans become more affordable, consumers borrow more money to purchase more goods, businesses hire more workers, and the economy expands.

The inevitable hangover, however, sets in when business owners discover that their more affluent clientele can afford to pay greater rates, so they do. Even worse, economists have shown that because inflation is partially a psychological phenomenon, public perceptions of it can become self-fulfilling.

Li stated, “Inflation is a lagging indicator.” But when it does, it can quickly get out of hand and turn into hyperinflation if inflation expectations are no longer grounded. This is history’s lesson, and if it is not grasped, it will inevitably be repeated.

Li and other economists cited Richard Nixon as an example, who pushed Fed Chair Arthur Burns to maintain low interest rates in the run-up to the 1972 election. Burns cooperated even though he was a well-respected economist and ought to have known better. This contributed to the country’s 1970s double-digit inflationary wave.

How much should Fed be influenced?

In their book “The Myth of Independence: How Congress Governs the Federal Reserve,” Binder and colleague researcher Mark Spindel from Georgetown University noted that Fed officials do take the public’s opinion, political opinion, and financial markets into account when making decisions. Transcripts of FOMC sessions made available to the public five years later, reflect their worries.

Congressmen in Congress, to whom Fed officials are answerable, often pressure them to adjust interest rates during open hearings. But even if Congress has changed the Fed throughout the years, the FOMC still has the last word on monetary policy.

Bullard, the former president of the St. Louis Fed, stated that “if it came right down to it, the Congress could do whatever it wants with monetary policy, so in that sense, it is political.”

However, after considering this for the past 100 years, Congress chose to keep it apart from the daily ups and downs in politics.

The public’s perception that the Fed will maintain inflation at its long-term target of 2% is a major factor in the Fed’s capacity to control inflation. A president’s obvious thumbs-up on the scales may jeopardise that.

According to Binder, “the Fed’s difficulty is its legitimacy and credibility. All of this boils down to the public’s trust that the Fed is capable and will carry out its tasks methodically, that it won’t just flap in the wind, blown about by rival political parties or beliefs.”

Binder is also concerned that the Fed would overreact in the other direction, maintaining excessively high interest rates in an attempt to maintain its credibility, which would needlessly hurt the economy by making money too scarce.

Stories from across the globe

Chief economist at Pantheon Macroeconomics, Ian Sheperdson, cited Britain as an example, where the elected government controlled the central bank until 1997. The Bank of England underwent a more independent reform to its leadership structure that same year. Coincidentally, that year saw Britain’s inflation, which had historically been several percentage points higher than that of the United States and Germany, drop to par with its counterparts in the economy.

The International Monetary Fund, the UN’s financial arm, conducted a study of 17 Latin American countries in 2022 and discovered that those with more independent central banks often had lower inflation rates.

Another striking illustration of the connection between politics and inflation comes from Turkey. Tayyip Erdogan, the authoritarian leader, experimented with an unconventional economic theory: that cutting interest rates would lower inflation. Rather, the rate of inflation reached 85.5% in 2023 before the central bank started to implement a more conventional strategy and increased interest rates.

Congress would ultimately decide whether to alter the Fed’s organisational structure. Bullard stated that, based on his discussions with lawmakers, he believes there is a minimal probability of that occurring.

Bullard stated that in casual discussion, “Even folks that you think could be kind of more extreme, either on the left or the right, they’re quite supportive. I didn’t get the impression that they were considering fundamentally altering the Fed’s structure.”

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