Fed is independent, but could markets be right about Trump's push for cuts?

Trump's push for democratic control of the Fed and its independence are not mutually exclusive

United States President Donald Trump’s decision to fire Federal Reserve Governor Lisa Cook has set off a firestorm among economic pundits. Ms Cook was sacked for allegedly producing false documentation while applying for mortgages. 

The pundits are right about one thing: Malfeasance has only provided Mr Trump plausible legal grounds for removing Ms Cook. The real reason is that Ms Cook is part of the majority on the Fed board that has refused to heed his repeated call for a reduction in interest rates. 

By firing Ms Cook, Mr Trump is sending out a message to members of the Federal Reserve board and the Federal Open Market Committee, the Fed’s policymaking body on interest rates: The Fed cannot be at odds with the President for long. Democratic accountability of the Fed, Mr Trump is saying, means that the elected authority should have a say in the conduct of monetary policy. 

This is not your columnist’s reading. It is exactly how US Vice-President J D Vance characterised the position in an interview with USA Today. As he put it: 

“Isn’t it a little preposterous to say that the President of the United States — the elected President of the United States, working of course in concert with Congress — doesn’t have the ability to make these determinations? I don’t think that we allow bureaucrats to sit on high and make decisions about monetary policy and interest rates without any input from the people that were elected to serve the American people.” 

Is this the end then of central bank independence? The end of the world? Not really, much as pundits would like us to believe it is so.

 

Central bank independence was formulated against the backdrop of double-digit inflation in the 1970s. When politicians controlled monetary policy, people learnt to expect high inflation. A wage-price spiral and high inflation followed. The lesson: Insulate monetary policy from politicians. Leave it to technocrats to implement an inflation mandate.

 

The world has changed since. Today, double-digit inflation is a rarity, and inflation imposes serious economic costs only when it is well into the double digits. Moreover, as economist Larry Summers has pointed out, governments have internalised anti-inflation norms, so government-driven monetary loosening is not the threat it was in the past.

 

Central banks work closely with the Treasury. The need for coordination has become greater for crisis prevention and response. If banks are to be saved with public money, the government has to be involved. If the Fed is to buy back government securities or non-government securities, that is a political decision because it benefits particular holders of securities. It is not sensible for a central bank to be taking these decisions independently.

 

In the US itself, there are serious concerns about the lack of accountability of the unelected technocrats who run the Fed.  Stephen Miran, chairman of the President’s Council of Economic Advisors and now nominated to the board of the Fed, has co-authored a paper that highlights serious infirmities in the institutional structure of the Fed.  (Reform the Federal Reserve’s Governance to Deliver Better Monetary Outcomes, Daniel Katz and Stephen Miran, Manhattan Institute, March 2024).

 

To illustrate, a member of the Federal Reserve Board of Governors  enjoys a term of 14 years, more than three times that of an American President. The chairman or a board member can be removed for impropriety but not for bad decisions that may impact millions adversely. The Fed’s board has representatives of the regional Reserve Banks, which are owned by private banks, the very entities the Fed is supposed to regulate! The authors ask whether such a structure is at all consistent with democratic accountability.

 

There is a self-serving presumption underlying the current notion of central bank independence. It is that technocrats are apolitical, utterly objective creatures who are guided by the public good in a way in which venal politicians are not. 

 

We know from experience that the reality is very different.  There is nothing noble, elevated, other-worldly or even especially refined about technocrats, including central bankers. Central bankers have political loyalties and are not above conducting monetary policy in ways that suit a particular party. In the US and in Europe, the “revolving door” syndrome, which involves technocrats hopping from the central bank onto government positions and back again, is ever-present. Central bankers tend to come from the ranks of the wealthy and their actions are often disconnected from the interests of ordinary folk. Politicians may be bad but unaccountable technocrats can be worse.

 

How then do we ensure democratic accountability of the central bank? For the Fed, Messrs Katz and Miran propose a number of reforms, three of which are worth highlighting. One, the term of a Fed board member should be reduced from 14 to eight years. Two, the President should have the right to remove Fed board members. Three, there must be a ban on Fed members serving on the executive branch for four years after demitting office.

 

Do these reforms spell the collapse of central bank independence? Not at all. We have before our very eyes a model of what Mr Katz and Mr Miran have in mind, namely, the Reserve Bank of India (RBI). The RBI governor typically has a three-year term. He can be removed by the government. In the Monetary Policy Committee, there are three officials of the RBI and three external experts appointed by the government. The RBI governor has the casting vote in the event of a tie.

 

The RBI governor works in consultation with the government, so the government has an input into the central bank’s decisions, whether on monetary policy or regulation. And yet the RBI has a creditable track record of performance. India’s central bank combines independence with democratic accountability.

 

If the Katz-Miran paper is anything to go by, a structure that has some of the features of the RBI is what the Trump administration would like to move towards. That is no cause for alarm. Perhaps that is why America’s financial markets are not showing any reaction to Mr Trump’s utterances and actions.

 

The Financial Times is disappointed and it almost urges the markets to revolt. It writes:  “…some analysts are concerned that investors aren’t taking Trump’s cumulative threats on the Fed’s independence seriously enough. ... Ultimately, more severe market ructions might be what is needed to force Trump to pull back from causing greater damage to the central bank and the US economy at large.” (FT, August  27)

 

Could it be that the markets think Mr Trump is right? That the economy will benefit from cuts in the interest rate  — and that fears of inflation getting out of control if he pushes ahead with his Fed reform agenda are exaggerated?

  ttrammohan28@gmail.com