Is The Independence Of The Federal Reserve In Danger?

In ancient Greece, the 'Titanomachy' was a battle between the Olympian gods (like Zeus) and the older gods, the Titans. Once victorious, Zeus condemned his vanquished opponents, notably Atlas, who was forced to carry the burden of the heavens, for eternity. While it's a stretch of the comparison that classical scholars should not forgive, when thinking of Atlas' feat of endurance, I have central banks in mind, and in particular, of the Federal Reserve, which has especially in the past fifty years borne the weight of investor expectations and the hopes of politicians.

The importance of the Fed cannot be underestimated – academics have shown that returns, volatility, and trading volumes are higher than average around the Federal Open Markets Committee meeting. The Fed has been at the epicentre of every financial crisis rescue effort through the globalization era – from the Asian, Russia, and LTCM crises, to the global financial crisis where the intellectual burden of finding a way of mending markets was shouldered by Ben Bernanke, to the recent responsiveness of the institution during COVID.

If anything, the Fed has been guilty of doing too much in recent years, and the consequences of its long deployment of quantitative easing are still becoming evident. On one hand, the large central banks, led by the Fed, are the glue that has kept the political economic peace throughout this thirty or so year period, but on the other, this peace has permitted the accumulation of huge amounts of debt, and has shielded politicians from the fiscal consequences of their actions.

Now, the independence of the Fed may be about to be sacrificed, as the president appoints Stephen Miran to replace Adriana Kugler who is stepping down, and a prospective chair to replace Jerome Powell who is due to step down in a year’s time as head of the Fed. The unwritten assumption is that, like never before, the Fed's rate setting committee will sway to the mood of the White House.

This is problematic at many levels. The suite of policies enacted by the president – from deportation to tariffs – means that the US economy is now suffering from stagflation (sticky inflation and low growth). Strip away the blinding effect of wild investment in AI, corporate America looks like corporate Europe. Stagflation is difficult for investors and central banks to navigate, and markets are pricing out rate cuts from this Fed.

Indeed, this is a very strange rate cycle. Historically, the Fed leads rate cutting cycles and other central banks follow, but the Bank of England, ECB, Royal Bank of Canada, and other smaller central banks like the SNB, have been hacking away at rates whilst the Fed has not moved this year.

The Politicisation Of The Fed

In the long-term, the potential politicisation of the Fed will augment uncertainty. There is already talk in central banking circles that in the event of a financial crisis, the politicised Fed may not be willing to open swap lines with other central banks, which if it occurred would deepen the economic effects of any crisis.

Swap lines across the international financial system have been staples of past rescues, and articles of faith for scholars of monetary systems like Charles Kindleberger. In such a context, the Fed's job as lender to (US) banks might also become more complex and ineffective if the large banks were to behave in the same way that the technology companies are now doing.

So, in a financial crisis, a large American bank could offer a large loan to the Trump family to extend the Mar-a-Lago resort, if the president sanctioned its main national and international rivals (cynics will ask whether something similar happened in 2009). My hunch is that beyond the thrill of lower interest rates (which will likely raise inflation and long-term bond yields), the vision that Trump has in mind for the Fed is something along the lines of the Bank of Japan, which in the past ten years has effectively swallowed the Japanese bond market.

The Risks Of A Politicised Fed

Having the Fed as a monetary hoover to keep bond yields stable will help to dampen some of the risks of indebtedness, but will store up greater risks for later. The appointment of a 'yes-man' at the head of the Fed (Kevin Hassett fits this role much more than the other leading candidate Kevin Warsh), will likely spur resistance within the institution, and across the regional Fed banks whose presidents help to make up the rate setting committee.

Not only will Fed employees – who are devoted to the institution – worry for their jobs (witness the hollowing out of the Bureau for Labour Statistics), but they will be concerned that the entire macro-landscape is being undermined – by weaker institutions, unreliable data, crypto and other 'new' money experiments, the acceptance of corruption and more volatile assets.

The ultimate objective of 'politicising' the Fed, if that is what is at stake, is to make sure that the next crisis doesn’t happen on Donald Trump’s watch. The risk is that when that crisis does happen, the Fed will be part of the problem rather than the solution.