Why the Damage to Fed Independence May Have Already Been Done

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2:00Hello and welcome to another episode of the All Thoughts Podcast. I'm Tracy Alloway. And I'm Joe Weisenthal. Joe, you wrote a good newsletter this week. Thank you. Thank you for saying that. Just that one. I wrote a good newsletter this week. No, but interesting week because obviously there's for months, you know, talk about Fed independence. Would President Trump try to fire Jerome Powell? All of these different questions. It's heating up. This is a very difficult topic to talk about podcast wise because there's always that chance that, you know, we record something on Fed independence. And by the time the episode is produced and edited, something new has happened.

2:38So very dicey. But, you know, we're hoping that in the next short period of time, this holds. But this is a really important story. We're recording this on July 18th, and I think the ambition is to get it out on July 19th. So hopefully nothing changes that quickly. But of course, you never know. And just this week, we have had these back and forth headlines. We had a report that Trump was considering firing Powell sort of imminently. And then he came out at a press conference and said, no, he wasn't. Yeah. And he said there was a report that there was a literal letter that was signed. Other people affiliated in the administration have been hammering Powell, some unrelated to monetary policy, some relating to the cost of renovations of the Federal Reserve offices.

3:19The criticism is, of course, getting intense. Anyway, I've been trying to learn more about this question of Fed independence. I came across a lot of the research that was done by economist Carol O 'Binder, which I thought was interesting, which talks about how Fed independence is this cherished idea in economics. But it's not just about the idea of whether the Fed is legally independent. Pressure on the Fed itself, even if the Fed doesn't necessarily react, just the rhetoric against the Fed and central banks around the world, not the Fed specifically, but central banks around the world, just the rhetoric and the pressure, the perception that the central bank is losing independence can have macroeconomic effects.

3:59Yeah. And despite some people cherishing that independence, we know from a lot of recent events, the rise of populism around the world that it seems a lot of people don't like unelected bureaucrats. Yeah, that's right. Just put it that way. Okay, so we actually have Kerala here. She is, of course, the Associate Professor of Economics in the School of Civil Leadership at UT Austin. How come? How come? How come? Kerala, thank you so much for coming on Odd Lots. Yeah, thanks so much for having me. Excited to be here. Do you just want to give us maybe a summary of your previous work and why you got interested in the subject of central bank independence in the first place?

4:38Sure. Yeah. I mean, the taper that was mentioned in the newsletter is one called political pressure on central banks. And in that work, I really wanted to understand this distinction between legal central bank independence, which we know has been rising around the world for the past couple of decades, versus actual or de facto central bank independence. Because it seems like even when the central bank does have legal protections that kind of insulate the bank from politics, there's still always going to be reason for politicians to try to convince the central bank to do what they want. I mean, that's the whole reason why we have legal protections on central bank independence.

5:21So it's kind of hard to measure that. What I ended up doing with the help of a couple of research assistants was reading through these reports by Economist Intelligence Unit that come out every quarter for basically every country. And just seeing whenever there was a mention of some kind of political pressure on the central bank. And we tried to record whether it was pressure for easier or looser monetary policy and also whether the central bank resisted the pressure or succumbed to it. And then once we had this new data set about all of these instances, at least all the known instances of pressure on central banks, then I was able to use that to say, well, what happens afterwards, especially to inflation?

6:04And as Joe said, if the central bank succumbs to the pressure, it's almost always pressure for looser monetary policy. So that's certainly followed by higher inflation. But even if they try to resist, inflation still rises, just not as much, but it still rises. So my My interpretation there is that it probably has something to do with expectations. So people start at least worrying that there's a chance that the central bank is going to give in to those pressures. They know that if they do, that'll be inflationary. So inflation expectations rise right now, and that makes inflation itself start to rise also.

6:42So to back up for a second, I described in the intro central bank independence, one of these sort of very cherished ideas and perceived as extremely important. What do you describe? Why is this actually? Because as Tracy mentioned, there's a lot of people who find it distasteful that there are entities within any government that aren't directly democratically accountable. What is it about central bank independence that is perceived by economists to be such a goal, so to speak? So the way I see it is two main parts. One is that there is a natural inflationary bias in monetary policy. So meaning if you had monetary policy controlled by elected politicians, they would always have this concern about the next election.

7:29They always want to make the public happy in the short term. So they're going to tend towards juicing the economy, even if in the longer run, that's going to cause inflation. So in equilibrium, you're always running monetary policy too loose and getting too much inflation. That happens if you don't have an independent central bank. So if elected officials are controlling monetary policy. The other side of it is think about the distinction between fiscal policy and monetary policy. So having independent central banks is very common. Having independent fiscal authorities is not. And the usual justification there is that fiscal policy has very obvious distributional consequences.

8:13I mean, that's basically the point of fiscal policy in some sense. Like you want, maybe you want progressive taxes. You want to spend on certain groups of people. You want to tax certain activities. And so that's inherently about distribution, which is something that you really want to be a political decision. You want the voters to decide about what kind of distribution they want. And monetary policy, on the other hand, is thought of as being a lot more even, right? It affects the macroeconomy more than it affects distribution. So in that way, it's like kind of more acceptable in a democracy to delegate it to some technocrats.

8:56That's kind of the like traditional case. But of course, that's been very much challenged, especially when the Fed during the financial crisis started doing more unconventional monetary policies. Those did have distributional consequences. They're kind of hard to measure, but they're there. And even conventional monetary policy like inflation is going to hurt some people more than others. Having a weak labor market is going to hurt some people more than others. So I think people do partly get dissatisfied with central bank independence when they realize that whatever the Fed is doing, I think maybe hurts them more than it hurts others or that they didn't have any say in that kind of decision, which it is political.

9:38Inflation is political and monetary policy is, too. You just reminded me on the topic of a natural bias towards loosening of monetary policy and therefore inflation. Do you ever get governments trying to pressure for higher interest rates? I feel like I can't come up with a single example. Well, it might not be obviously for higher interest rates, but one of the few examples in that paper that I found of pressure for tighter monetary policy was in the U.S. after the financial crisis when the Fed was doing so much QE. A lot of Republicans in Congress especially were worried that that was going to be very inflationary.

10:18So they were pressuring the Fed to cut back on the QE or not do so much monetary easing. Those were wild times when a lot of people, myself included, probably thought QE was going to be inflationary. Yeah, or people thought it was going to be hyperinflationary. The more cynical interpretation, by the way, is not that Republicans thought that – and this is just the cynical interpretation. I'm not even saying I'm going to say this, but not that they were worried about inflation, but that they didn't want the economy to recover particularly rapidly under a Democratic president. Again, different perceptions of what their motivations are.

10:54Okay. One of the things people say, and you talk to veteran people on Wall Street, and they're like, they've always done this. This is nothing new in this country. Every president has, in some way, tried to pressure their central banker, typically for easing in some way. And I think there's certainly examples of that without question. How novel and different. When we talk about they're attacking them over the cost of renovations, they're directly saying, cut 300 basis points in a tweet, et cetera. Does this feel like a meaningful step up in the level of pressure that we've historically seen in the U.S.?

11:30Yeah, I think the meaningful difference is that it's so public now and so obvious where it used to be like there was this protocol, right, that the president might want lower interest rates, they might want easier monetary policy, but they're not going to say so out loud. There was a lot of just careful procedure around it. So the fact that it's really, really like a public spectacle now is a difference. It does, I think, further politicize the Fed because now the general public sees the president tweeting about the Fed and depending on whether they support the president or not, they might be more angry at the Fed or more defensive of the Fed.

12:11So it really makes it public in a way that is pretty new. But I mean, And I do get the point that there is always this pressure on the Fed, always from within Congress, too. You've had criticism of the Fed, which coming from Congress, it's a bit more appropriate than from the president because the Fed is accountable to Congress. So it kind of makes more sense that you would see a lot of criticism of the Fed coming from Congress because that's more their role. They have the monetary power that they've delegated to the Fed. Right. I know you're not in the sort of market coal mines on a daily basis, but I'm hoping I'm hoping you may nevertheless have an opinion on this, because one of the weird things that happened this week when all the headlines about Trump possibly firing Powell started to fly around was the biggest reaction in the market seemed to be in the dollar in the U.S.

13:05currency. And we actually didn't see that much movement in yields, at least going up. Like they didn't start surging. So I guess I'm curious if your thesis holds that any type of pressure tends to be inflationary because it boosts perceptions of inflation. Why wouldn't we have seen an upward rise in yields, that reaction this week? Well, it's not that any type of pressure is inflationary. that on average, across all of these hundreds of data points I was looking at, on average, pressure was inflationary. This particular case could be very different. I think partly because there's so much uncertainty about what is Trump actually going to do.

13:49It's hard to even follow the news here where he says he's going to fire Powell or no, he didn't. So any kind of announcement you get. I think the markets don't know exactly how to take it right away. And some of the news was already kind of baked in. We've known for a couple of months that President Trump was having this conflict with Chairman Powell. So maybe these most recent announcements are not really that much new news.

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16:33Crypto trading provided by Backed Crypto Solutions, LLC. Complete disclosures available at public.com slash disclosure. Has the damage already been done? This is the sort of question that I'm wondering about, which is that, okay, pressure has existed to some extent forever. It's become much more of a public spectacle. It's become much more aggressive, et cetera. There is this, I would say, safe assumption that Powell doesn't have that much longer in his term, but that the assumption is that the next Fed chair will be some sort of capital L loyalist to Trump, that there will be alignment. I forget who it was on TV talking about, we need a new Fed treasury accord.

17:12So would you say like to some extent that the glass has been broken here or the glass has been cracked and that the damage has been done, even if the Fed legally retained its existing structure, that the Fed going forward will not be the same independent Fed, will not be as independent as we've had for the last several decades? Yes, I think that the damage to the perception of the Fed's independence has already been done. There are really big political divides in how people perceive the Fed, the kind of tradition that one president would reappoint the previous president's Fed chair, even if they were from a different political party.

17:55I think that that tradition probably is over. Yeah. Kind of like Supreme Court nominations, which used to fly through now are entirely done on political, like the votes and the confirmation votes are completely political now. Yeah. But I would say it's not just the fault of Trump since his election, since his most recent election. It's not just that. It's also what was happening during the pandemic and during the high inflation episode in 2021 and 2022. That did a lot of damage as well, because there was so much on both sides of trying to place the blame and saying, was everything the Fed's fault?

18:37Was everything the fault of the fiscal stimulus? Was inflation transitory or permanent? That really got things more politicized then, and that's only been exacerbated by the past couple months. One of the other narratives that I've seen this week is this idea that, OK, even if Trump fired Powell and put in place someone who would immediately push for lower interest rates, you wouldn't necessarily get them, A, because of the market expectations, which you just described. So people might start pricing in higher inflation expectations, which would move the curve up or steepen the curve. But also because it's not just the Fed chair making decisions, it's a committee.

19:22And Trump might not be able to influence the entire committee. How do you take into account, I guess, the rest of the FOMC members? How do they play into this type of political pressure? Yeah, so it is monetary policy by committee. And under different Fed chairs, the kind of committee decision making has differed a little, just the norms around it. So whether they, like, kind of how strong the Fed chair was in making sure that everyone would come to a consensus versus allowing some more disagreement to be public. But, yeah, I think the fact that the members of the committee have these overlapping terms and pretty long-term lengths is part of what gives it independence because it means we don't have a complete turnover of the committee at any given point in time.

20:14And there's going to be a lot of continuity there because of that institutional structure, especially if you get a Fed chair that's kind of external, that's viewed as a loyalist. The rest of the committee may be quite reluctant to just go along with whatever the new Fed chair says if they don't feel like it's the right decision. The Fed, they emphasize all the time that they're data dependent. And I think that's the line that a lot of committee members would keep using. The unfortunate thing is we don't know exactly in what sense they are data dependent. They don't publish a monetary policy rule that they follow, but they say that they take into account not just the PCE inflation rate and the unemployment rate, but all sorts of other indicators about where the economy is headed.

21:03And they react to all of those. So I'm pretty sure most of the committee would try to just stick to the course that they're on, even if there were a new chair in place. It would be really interesting because dissents are very rare. And sometimes you get a lot of times you get no dissents. Sometimes you get one. Very rarely you get two. In my career, I can't remember any decision in the US that I think ever got more than two dissents. It would be interesting if that norm were broken where the Fed really does not control or have basically get to guide the committee on their preferred path. I want to talk about in the broad research globally.

21:43Establishing a independent central bank is politically difficult. And some countries attempt to do it by simply outsourcing their monetary policy to the Federal Reserve itself by setting up a dollar peg or a currency board or something like that, because they don't even have the sort of political capacity to establish a truly independent central bank. What are the patterns you see around the world? I'm curious if in your research, when pressure builds on a central bank, is it usually sort of a symptom of a broader domestic political disintegration that's happening where just all kinds of norms are being violated or all kinds of structures are sort of collapsing or deteriorating in some way?

22:25Yeah, well, to the part about how the central bank independence is set up, sometimes it's because there's already a very strong preference in that country for lower inflation. So then it's kind of easier to set up an independent central bank because they really want low inflation and they're committed to it, which is why it's so hard in the research to say, does central bank independence actually lower inflation? Because you have like a reverse causality. So sometimes that's how it gets set up. Sometimes it's imposed by like the IMF saying, you know, if you want to keep having our support, there's some things you need to do.

23:00And one of them is set up an independent central bank. But then the part about like, when do politicians start? pressuring the central bank? When does that really build up? Yeah, I mean, there was a lot more of the pressure on the central banks around crisis times. So I think the financial crisis did erode a lot of trust in institutions and made it more acceptable to pressure central banks. Also, during the 2010s, when inflation was really low, that made it seem more like, okay, having higher inflation doesn't necessarily seem like so much of a threat. What we really want is to boost the labor markets, at least in certain countries.

23:46So then there was more pressure on the central banks that way. The other thing is also like the fiscal situation. So if there's big, big debts to finance, right, and then there's going to be often pressure for the lower interest rates or to monetize the debt. Tracy, by the way, just as we're recording this headline from the AP, all this stuff about criticism of the Fed, it turns out Chris Rugerberg, Josh Boak of the AP reporting much of these costs were associated in 2020 with Trump officials demanding that there be more marble at the Fed instead of glass. So a new wrinkle to the cost of these office constructions.

24:23Anyway, you got to have that marble. Trump loves marble, marble and gold. He does have a very Louis XV style, I guess, tastes in interior design. Anyway, maybe we should do an interior design. Yeah, I'm done. I would like that. Okay. Anyway, on a serious note, given those concerns around trusting unelected bureaucrats and the idea that maybe, you know, central banks started to overstep their traditional roles post 2008 or something like that, what's the best way of, I guess, ensuring that central banks are in some way answerable to the electorate or in some way, you know, there's accountability there without sacrificing that independence.

25:10Yeah, I mean, this is a really important topic to me and something I focus a lot on in my book and in some of my other research. But I think that making sure that the role of the Fed or the central bank is limited to something like price stability and having a lot of transparency about how they're achieving that is really important. So the Fed has a dual mandate. Having the price stability and the employment side of the mandate gives them a lot of discretion because sometimes those two goals can come into conflict and then they need to just decide, well, what are we going to prioritize right now?

25:46The more discretion that unelected technocrats have, the more room there is for people to try to pressure them one way or the other. In my book, I advocate for a nominal GDP or a nominal income target, which I think would help them achieve both parts of that dual mandate, but with a single target that they're going after. And then it makes it really clear at any given point of time, do they need tighter or looser monetary policy? And there's not as much wiggle room. It makes it easier for them to justify their actions and for the public to say, well, are they doing what they say they're going to do or not?

26:24Versus if you have an inflation target and kind of full employment target, then you can always argue kind of for either way. And yeah, so just keeping the role more limited, not lately, but before COVID, there was a lot more pressure on central banks to do even more beyond those kind of two parts of the dual mandate to take on climate change and inequality and issues like that. And I think that those are important things that somebody needs to do, but it's not really the job of the Fed because they're not elected to do that. And those kinds of political topics need to be addressed by elected officials.