What Would Happen If The Federal Reserve Answered To The President?

What You Need to Know

• Advisors to presidential candidate Donald Trump have reportedly circulated plans to bring the Federal Reserve more under the president’s control.
• Economists say the Fed’s independence, and the public’s belief in it, is important to the central bank’s ability to keep inflation down.
• In the past and in other countries, political control of central banks has led to higher inflation.
• Political leaders tend to want lower interest rates that benefit the economy in the short run, but which can cause higher inflation down the road.

Who should control America’s money supply: the experts, or elected representatives of the people? 

A long-running debate about who should run America’s central bank flared up again last month after The Wall Street Journal reported that members of Trump’s inner circle have passed around several proposals for bringing the Federal Reserve, with its crucial role in running the economy, more under the president’s control.

Economists have said that handing the Fed’s policy decisions over to a president would almost certainly lead to higher inflation. Most presidents would likely pressure the Fed to keep its benchmark interest rate lower than it otherwise would, worsening inflation. 

“The evidence is pretty clear that if you give up an independent central bank you’re going to get higher and more variable inflation eventually,” said James Bullard, former president of the Federal Reserve Bank of St. Louis, who served on the Fed’s policy committee between 2008 and 2023.

Sarah Binder, a professor of political science at Georgetown University, and an expert on how politicians influence the Fed, pointed to the “stagflation” era as a cautionary tale. The double-digit inflation and economic stagnation of the 1970s happened partly because presidents Lyndon Johnson and Richard Nixon pressured the Fed to lower interest rates, she said. 

“The record of the 1970s shows that that type of political pressure helped to unleash inflation for over a decade,” she told Investopedia. “It’s not a foregone conclusion that the Fed would bend to Trump’s will, but it certainly puts the Fed in a particularly politically precarious position.”

The Fed’s Independence

The Federal Reserve is an unusual part of the U.S. government in that it’s designed to be insulated, at least to some extent, from influence by politicians. 

The Fed was established in 1913 to stabilize the financial system after a wave of bank failures, and its powers have grown over the years. It’s now responsible for regulating banks and, crucially, setting the nation’s monetary policy. 

Congress tasked the Fed with a dual mandate in 1977—control inflation while keeping the economy at full employment. It does this mainly by manipulating the fed funds rate, which determines the interest rate at which the nation’s banks lend money to one another. This influences rates for all kinds of other loans throughout the economy, including business and personal loans such as mortgages.

Decisions on raising and lowering interest rates are made by a committee that is a mix of presidential appointees who serve 14-year terms and regional bank presidents who serve one-year terms on a rotating basis. 

Because the president is only ever able to appoint a handful of Federal Open Market Committee (FOMC) members during any given term in office,  the committee has greater freedom than other federal agencies to operate as technocrats and make decisions based on what they deem to be wise economic policy, rather than political considerations—at least in theory. 

Critics of the Fed have long sought to bring the central bank more under the control of the other branches of government. They often argue the public isn’t able to hold the Fed accountable because of its independence, making its governance undemocratic. Critics have also called the Fed’s economists unelected bureaucrats, saying they shouldn’t be allowed to make economic policy decisions.

Why More Politics Would Lead To Higher Inflation

The Fed has been in a particularly bright spotlight the past few years as it steadily raised the fed funds rate to tame inflation that had risen far above the central bank’s 2% target level. The range for the benchmark rate is currently at a 23-year high of 5.25%-5.50%, where its been since July.

The tight monetary policy has helped bring inflation down, which has led to hopes among consumers and investors that interest-rate cuts may be on the horizon. However, Fed officials have said they need more confidence that price pressures are under control before easing policy.

Economists warn a Fed that answers to the president is one that would be more likely to let inflation run rampant.

Presidents have every reason to pressure the Fed to lower interest rates and have done so in the past, partly because election cycles push them into short-term thinking, said Victor Li, a professor of economics at Villanova.

When the Fed sets interest rates extra low, loans are cheaper, people borrow more to buy more stuff, companies hire more workers, and the economy booms—all great things for a president to have happen on their watch. 

“Low interest rates may temporarily lead to a lower unemployment rate, which looks great for an incumbent running for reelection,” Li said in an email.

But then comes the inevitable hangover—merchants find that their customers are richer and can pay higher prices, so they raise them. Worse, because inflation is partly a psychological phenomenon, economists have found that popular belief about it can become a self-fulfilling prophecy

“Inflation is a lagging indicator,” Li said. “But when it comes, it can easily spiral out of control and become hyperinflation when inflation expectations become unanchored. This is the lesson of history and it’s doomed to repeat when it is not understood.” 

Li and other economists pointed to the example of Richard Nixon, who leaned on Fed chair Arthur Burns to keep interest rates low ahead of the 1972 election. Despite being by all accounts a respected economist who should have known better, Burns complied, helping set off the bout of double-digit inflation the country experienced in the 1970s. 

How Much Should The Fed Be Influenced? 

To be sure, the Fed is not, in reality, completely removed from politics.

As Georgetown’s Binder and fellow researcher Mark Spindel documented in their book, “The Myth of Independence: How Congress Governs the Federal Reserve,” Fed officials do consider how their actions will be received by politicians, the public, and financial markets. Those concerns show up in transcripts of FOMC proceedings, which are released to the public after five years. 

Fed officials must answer to lawmakers in Congress, who, at public hearings, frequently urge Fed officials to move interest rates in one direction or the other. Congress, however, despite having reshaped the Fed over the years, has left the final say on monetary policy up to the FOMC.

“If it came right down to it, the Congress could do whatever it wants with monetary policy, so in that sense, it is political,” Bullard, the former St. Louis Fed president, said. “But Congress has looked at this over the last 100 years and decided to keep it at arm’s length from the day-to-day political to and fro.”

A large part of the Fed’s ability to shape inflation comes from the public’s belief that it will keep inflation running at its long-term goal of 2%. That could be undermined if a president were to blatantly put their thumb on the scales.

“The challenge for the Fed is its credibility, its legitimacy,” Binder said. “It’s all wound up in the public having confidence that the Fed knows what it’s doing and that it’s going to do it in a methodical way. That it’s not going to simply twist in the wind, buffeted by competing parties or competing ideologies.”

Binder also worries the Fed could overreact in the opposite direction, keeping interest rates too high in an effort to defend its credibility, unnecessarily damaging the economy by keeping money too tight. 

Cautionary Tales From Around The World

Ian Sheperdson, chief economist at Pantheon Macroeconomics, used Britain as an example, where the central bank was under the control of the elected government until 1997. That year, the Bank of England’s governing structure was changed to make it more independent. Not coincidentally, British inflation, which had been chronically several points higher than in the U.S. and Germany fell into line with its economic peers that year. 

A study of 17 contries in Latin America by the International Monetary Fund, the financial arm of the United Nations, in 2022, found that inflation consistently ran lower in countries where central banks had more independence. 

Turkey provides another dramatic example of the link between politics and inflation. Authoritarian ruler Tayyip Erdogan tried out an unorthodox economic theory: that lowering interest rates would reduce inflation. Instead, the inflation rate got as high as 85.5% in 2023 before the central bank began using a more traditional approach, and raised rates.

Ultimately, the decision to change the Fed’s structure would be up to Congress. Bullard said he sees little chance of that actually happening, based on conversations he has had with lawmakers.

“Even people that you think might be kind of more extreme, either on the left or the right, they’re pretty supportive in ordinary conversation,” Bullard said. “I didn’t get the sense that they were seriously considering changing the structure of the Fed in a fundamental way.”

Read the original article on Investopedia.