Trump’s target is not only Powell but US Fed’s inflation independence

Has the President’s latest outrageous attack on the Federal Reserve chair signalled the end of a broadly successful monetary policy era?

Monetary policy reached the ‘end of history’ in the 1990s, with central banks universally prioritising price stability through the adoption of inflation targeting. Has Trump’s latest outrageous attack on the Federal Reserve chair signalled the end of this broadly successful policy era?

Politicians gave their central banks a high degree of operational independence to set short-term interest rates, accepting that maintaining price stability would sometimes require politically unpopular high interest rates.

The US did not formally adopt inflation targeting until 2012, but the Fed pioneered the inflation-prioritising model in 1979. Paul Volcker’s bold action to raise short-term interest to nose-bleed levels broke the entrenched inflation of the 1970s.

Moreover, it marked the end of political interference in interest-rate setting. Richard Nixon had lent on Fed chair Arthur Burns to lower interest rates to support Nixon’s 1972 re-election, which succeeded in that objective but contributed to the stagflation of the 1970s. Jimmy Carter and Ronald Reagan squirmed throughout the extended Volcker Shock, but accepted that it was necessary medicine.

At least until now, no subsequent president has interfered with the Fed’s interest-rate setting, although complaints have been common enough. George H Bush blamed Alan Greenspan for his re-election failure in 1992 and his son was no fan of the Fed.

Perhaps Trump has in mind that his newly servile Fed would go back to the policies that followed the 2007-8 financial crash.

Trump has gone much further. He has kept up a barrage of insults and derision aimed at Jay Powell. The latest assault involves the seemingly exorbitant cost of renovating the Fed’s buildings, but this is just convenient ammunition. As Powell says: ‘this action should be seen in the broader context … It is about setting interest rates …’

The onslaught has been personal and might seem to be aimed at Powell’s dismissal or forced resignation. But Powell’s term as Fed chair ends in May. What is the point in removing him? For Trump, it is more important to demolish, once and for all, the Fed’s independent power to set short-term interest rates. Altering the institution is even more important than asserting personal power.

Appointing a supine chair to replace Powell might be enough. Trump is already limbering up to do this. But there is always the possibility that the most loyal minion might assert unexpected independence once appointed.

There is precedent here. Harry Truman assumed that William McChesney Martin would do the presidential bidding, but Martin turned out to be an inflation fighter, remembered for his policy principle that it was the job of the Fed to ‘take away the punch-bowl just when the party is getting to be fun’. And there is the uncomfortable precedent of Arthur Burns, who has gone down in central bank annals as the man who let down the team by giving in to Nixon. Who wants to be remembered this way?

A Trump win here might be a pyrrhic victory. Why did his predecessors – Carter, Reagan and the two Bush presidents – all put up with Fed actions they disliked?

They recognised that inflation is politically unpalatable and that it was best to delegate the required painful policy measures. Trump, former property developer is, perhaps, not averse to some inflation to push up asset prices. But it might not be as simple as he thinks.

First, there is the question of whether a low Fed Funds rate would lower borrowing costs. Mortgages and commercial borrowing are based on longer-term rates. While there is normally a close connection between the Fed’s rate and the bond rate (the 10-year bond rate reflects the market’s expectation of the Fed Funds rate over the next 10 years), if the market decided that an abnormally low setting would be unsustainable and would set off inflation, then the bond rate will increase rather than mirror the lower Fed Funds rate.

Perhaps Trump has in mind that his newly servile Fed would go back to the policies that followed the 2007-8 financial crash, when the Fed not only implemented a near-zero Fed Funds rate, but used Quantitative Easing to lower longer-term rates as well. This departure from the 1990s policy model set an unhappy precedent, opening the way for a return to the bad old days when central banks helped governments fund budget deficits.

But this would run into a more fundamental downside. Trump’s target interest rate of 1% would, in inflation-adjusted terms, be better-than-free money, a sure recipe for inflation. Trump’s undermining of Fed independence would demolish the key benefit of the inflation-targeting framework – its ability to anchor price expectation and keep inflation on an even keel.

Both Gerald Ford and Jimmy Carter learned the political cost of letting inflation rip. Will Trump have to issue his own version of Ford’s WIN (Whip Inflation Now) election buttons?

How will this all turn out? Trump’s tariff gyrations demonstrated that policy-making can stir up a lot of dust before settling on a less-disastrous equilibrium. Doubtless Trump wants to change the relationship between the executive and the Fed. But there is a lot of inertia in the institutional structure. Interest rates are set by a committee, whose members have long tenure. Past Fed chairs have been able to dominate policy setting, but a Trump acolyte won’t have the authority of Greenspan, Bernanke, Yellen or Powell.

Should we look to the financial markets for a best-guess of the outcome? In response to the news of the threatened prosecution, the exchange rate moved down a fraction of a percent, and it was hard to see any effect on bond yields. Just another day in Washington.​