The Fed must be insulated from Trump’s political objectives

Thursday, President Trump remarked that he was “not thrilled” the Fed was raising interest rates, saying that the administration was putting “all of this work” into the economy “and then I see rates going up.”

These comments come one day after Federal Reserve Chairman Jay Powell insisted on the importance of the independence of the Federal Reserve during his semi-annual testimony to Congress.

{mosads}While the independence of central banks is often taken for granted in advanced economies, it is a relatively novel concept and one that must remain a guiding principle for monetary policy.

While low inflation in advanced economies may lure us into a false sense of comfort, the U.S. inflationary experience of the 1970s should remind us that political influence on central banks can have dire consequences for an economy.

The argument for making monetary policy insular from politics can be traced back to the stagflation years in the 1970s when economists started recognizing the importance of dynamic inconsistency. The concept, while sounding complicated, is intuitive.

If central banks are governed by political incentives, they will tend to stimulate the economy in the lead up to elections. Monetary policy stimulus would boost economic output and employment and would lead to increased wage growth.

Once the short-term economic and political gains would be achieved, the central bank would pull the stimulus back. However, households and businesses would expect further stimulus down the road, so that inflation expectations would remain anchored at a higher level, and inflation would permanently settle higher, gradually eroding households’ purchasing power.

Political influence on the Fed can have dire economic consequences

The most recent example of political influence on the Federal Reserve came in the early 1970s when President Nixon nominated Arthur Burns to chair the Federal Reserve after Fed Chairman William McChesney Martin was pushed toward the exit.

Once confirmed, Fed Chair Burns was pressured into maintaining a policy of low interest rates to promote growth and present a solid economy ahead of the presidential elections of 1972. Nixon’s orders were clear as he told Burns “[…] we’ll take inflation if necessary, but we can’t take unemployment.”

Loose monetary policy implemented by the Federal Reserve along with the oil price shocks in the 1970s would eventually push inflation to 9 percent in late 1973, and 12 percent in late 1974.

A second oil price shock in the late 1970s would then push inflation close to 15 percent in 1980, and it took a drastic action by the Federal Reserve and half a decade to stabilize inflation below 5 percent.

This process started with Federal Reserve Chairman Paul Volcker raising the key policy rate to 20 percent in mid-1981, which eventually drove the economy into a deep recession. This, in turn, drew strong political criticism and widespread opposition to the Federal Reserve, but at last inflation expectations were re-anchored at lower levels.

….The United States should not be penalized because we are doing so well. Tightening now hurts all that we have done. The U.S. should be allowed to recapture what was lost due to illegal currency manipulation and BAD Trade Deals. Debt coming due & we are raising rates – Really?

— Donald J. Trump (@realDonaldTrump) July 20, 2018

Fed independence is crucial even in a low inflation environment

In their seminal work on central bank independence and macroeconomic performance, Alberto Alesina and Lawrence Summers (1993) showed that central banks that are politically influenced were more likely to conduct policies that would lead to “high and variable inflation.”

Further, while reviewing 16 Organization for Economic Cooperation and Development economies, they showed that countries with independent central banks generally had lower inflation without “suffering any output or employment penalty.” As such, central banks acting outside of the political sphere of influence would be most desirable in any country.

However, in a world where inflation appears to have become anchored at low levels, one could argue that central bank independence is no longer essential, and that we shouldn’t put as much emphasis on this tenet of monetary policy. This would be a mistake.

At the 350th anniversary of the Riksbank, Sweden’s central bank, Fed Chair Powell addressed the issue of “public transparency and accountability of central banks in a time of intense scrutiny and declining trust in public institutions.”

His speech highlighted the importance of central bank independence in the wake of the global financial crisis and at a time when trust in public institutions is at historic lows.

While current conditions are very different from those of the 1970s, we must not forget that the premise of central bank independence rests on the advantage of insulating monetary policy from short-sighted political objectives.

While inflation expectations are currently well anchored, history shows us that a pervasive lack of central bank independence can rapidly, and without warning, lead to rising inflation and economic instability.

As Powell stated, the key reason why most central banks are given this independence is to “safeguard against political interference.” This provides central bankers with the ability to determine what actions to pursue to achieve the central banks’ mandated objectives.

In the case of the Fed, Congress determined via the 1977 Federal Reserve Act that the Federal Reserve’s statutory objectives were “maximum employment, stable prices and moderate long-term interest rates.”

This political independence allowed the Fed to respond aggressively to the deteriorating economic conditions of the last crisis, and act swiftly to alleviate the collapse of financial intermediation.

Without this instrument independence, the Federal Reserve would likely have been too slow and too bureaucratic to implement counter-cyclical policies, and the recession would most likely have been deeper and longer than it was.

In all, it is clear to see that central bank independence is, and must remain a guiding principle for monetary policy. While low inflation in advanced economies may lure us into a false sense of comfort, the U.S. experience of the 1970s should remind us that political influence on central banks can have dire consequences for an economy.

Gregory Daco is the chief U.S. economist for Oxford Economics, a firm that provides research on major economies, the emerging markets, commodities, industrial sectors, global economics, global industry, cities and regions.