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KEY INSIGHTS October 29, 2018 KEY INSIGHTS October 29, 2018 Fed Under Fire: Is the Independence of the U.S. Federal Reserve at Risk? By: Robert F. Wescott, Ph.D., and Serena Mackool Key Insights Since July 2018, President Donald Trump increasingly criticized the U.S. Federal Reserve for raising its benchmark rate rate, leading some to question whether the Federal Reserve’s independence is in danger. President Trump’s attacks are unlikely to directly affect Fed policy, but could erode public confidence in the independent institution, rendering its countercyclical policies less effective in the face of the next recession. Trump’s attacks on Fed policy are likely to grow in frequency and intensity as the next presidential election draws nearer, particularly if the US economy fails to sustain its current pace of growth. What is happening? In July 2018, President Donald Trump publicly criticized the US Federal Reserve for raising its benchmark interest rate, violating the White House’s longstanding protocol of refraining from commenting on monetary policy. 1 Although the White House press secretary and Trump advisors immediately assured the public that the President respects and recognizes the importance of the Federal Reserve’s independence, Trump’s criticism of the Fed’s policies continued President Trump’s throughout the summer and rapidly escalated following the Fed’s September decision to publicly decision to raise its benchmark rate for the third time this year. With the target criticize the Federal federal funds range now set at 2 to 2.25%, the President has pronounced the Fed Reserve for raising “crazy,” “wild,” “loco,” and “ridiculous,” while claiming that increases in its its benchmark benchmark rate are “too aggressive,” and “a big mistake.”2 interest rate has led some to question whether Significance. Against the backdrop of a highly-charged partisan environment, the Federal Trump’s decision to break with decades-old tradition has alarmed policy and Reserve’s status as financial circles alike, leading some to question whether the Federal Reserve’s an independent status as an independent institution is at risk. Such concerns have arisen at a critical institution is at risk. point in the Fed’s history, sowing uncertainty about the central bank’s impartiality as it seeks to normalize interest rates and keep a thriving US economy from overheating, whilst taking pains not to trigger an unwarranted economic contraction. If the Fed’s independence is compromised, the executive branch could leverage its newfound influence over monetary policy to ensure favorable Fed Under Fire: Is the Independence of the U.S. Federal Reserve at Risk? economic outcomes in the short term, resulting in the mismanagement of this delicate process and raising risks of inflation in the future. Background. Although the US Federal Reserve was established in 1913, its independence was not enshrined until 1951, when the US Treasury and the Federal Reserve reached an agreement to separate the management of government debt from monetary policy.3 Still, this did not immediately translate into a policy of non-interference, and for decades afterwards presidents publicly and privately placed pressure on the Fed to adopt certain policy actions, particularly in election years. For example, in 1965 Lyndon B. Johnson demanded that Federal Reserve Chairman William McChesney Martin Jr. reduce interest rates, fearful that higher rates would compromise his ambitious domestic agenda.4 Similarly, in the run up to the 1972 election, Richard Nixon pressured Arthur Burns to adopt expansionary monetary policy, and in 1991, George H.W. Bush urged Alan Greenspan to alter Fed policy in an effort to reach specific economic growth targets. 5 Nonetheless, the Fed’s independence prevailed: Martin refused to succumb to Johnson’s demands, and Bush blamed his 1991 electoral defeat on Greenspan’s refusal to lower interest rates.6 Furthermore, while political pressure from Nixon likely encouraged Burns to adopt expansionary monetary policy, the Chairman appears to have acted out his own conviction, rather than at presidential behest.7 President Trump’s comments on Since the early 1990s, however, presidents have refrained from commenting on monetary policy Fed policy. Bill Clinton, George W. Bush, and Barack Obama all avoided speaking have broken more about the Fed’s policies, supporting the institution’s full independence. Following than two decades more than two decades of presidential silence on such matters, President Trump’s of presidential comments on monetary policy have proved unsettling. silence on such matters. A threat to independence? Trump’s attacks on the Fed have galled financial and policy circles, but are unlikely to directly affect Fed policy. A strong historical precedence for Fed independence has set expectations for Federal Reserve Chairman Jerome Powell to maintain the Fed’s impartiality, and will serve as a protective force for the institution. Additionally, the actions of today’s Board in the face of Trump’s criticism suggest that this legacy of independence will continue. Despite Trump’s comments this June, the Fed followed through on plans to raise its benchmark rate in September, and signaled its intention to implement a fourth rate increase in December 2018, indicating that it will disregard the President’s preference for low rates. 8 Additionally, Powell has repeatedly expressed an unwavering commitment to the development of independent Fed policy and refused to comment on policies outside of the Fed’s purview. Thus, both the Fed’s policy actions and communications suggest that the executive branch continues to have no say in monetary policy. Furthermore, despite his heated rhetoric, Trump has appointed qualified, mainstream technocrats to the Board of the Federal Reserve rather than taking an 2 Fed Under Fire: Is the Independence of the U.S. Federal Reserve at Risk? easily-accessible partisan route. His appointees to date include Vice Chairman Richard Clarida, a widely-respected economics professor, and Vice Chairman for Bank Supervision Randal Quarles, a lawyer who previously worked in the Department of the Treasury.9 Trump also appointed Fed chairman Jerome Powell, The Fed’s policy who originally joined the Board under Obama, and has recently nominated Nellie actions and Liang, another Obama-era appointee. 10 His selection of these mainstream communications economists from both sides of the isle, rather than individuals likely to cater to suggest that the presidential demands, suggests that despite his criticism, Trump’s choices are likely executive branch to support the continued independence of the Federal Reserve. This notable continues to have contradiction has led to speculation that the President’s tirades against the Fed no say in monetary policy. constitute a contingency plan, such that in case of an economic downturn, he can redirect blame from his administration to the Fed’s interest rate hikes. 11 Nonetheless, whether Trump views the Fed as the ideal scapegoat or as a pillar of the US economy, his attacks do not pose a direct threat to the body’s independence. A threat to legitimacy? Trump’s attacks are thus unlikely to compromise the Federal Reserve’s independence; however, they do have the potential to challenge the institution’s legitimacy before Congress and the American electorate. Trump has already established a pattern of eroding public trust in institutions that he believes have wronged him: following his censure of the FBI, support for the law enforcement agency among Republicans declined by 13 percentage points, and today, almost half of Republicans hold an unfavorable opinion of the FBI.12 The potential for a similar loss of confidence in the Fed constitutes a genuine concern. Lack of public trust in the central bank could undermine its ability to influence the expectations and behavior of financial markets, businesses, and average Americans, rendering its crucial countercyclical policies less effective in the face of the next recession. Furthermore, widespread mistrust could push Congress to exercise its power over the Fed’s statute, with repercussions for the bank’s authority and independence. The experience of the Bank War waged by President Andrew Jackson and his Jacksonian Democrats against the Second Bank of the United States reveals how diminishing public confidence might pose a threat to the Fed and its mandate.13 While Trump’s Launching a personal battle against the once-esteemed institution, Jackson attacks may not leveraged fiery rhetoric to convince the American electorate that the Second directly impact Fed Bank was unconstitutional and had failed to support the US economy. His independence, his delegitimization campaign wiped out faith in the bank among American voters capacity to shift and Congress, and ultimately resulted in the incapacitation and demise of the public and institution through Congress’s refusal to renew its charter. History thus shows that congressional opinion could have while Trump’s attacks may not directly impact Fed independence, his capacity to repercussions for shift public and congressional opinion against the bank could have repercussions the Fed’s statute for its congressionally-administered statute and authority down the line. and authority down the line. This threat is heightened by the fact that some lawmakers are already skeptical of the Fed. Congressional support for the bank declined following the 2008 financial 3 Fed Under Fire: Is the Independence of the U.S. Federal Reserve at Risk? crisis, with policymakers
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