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Somewhere within the recesses of the Donald Trump campaign, according to the Wall Street Journal, is a 10-page document of — and we don’t say this lightly — earth-shaking ramifications.
The document purports to lay out a vision for a particular aspect of a prospective Trump presidency: to gnaw away at the independence of the Federal Reserve, which sets the policy rates that determine the course of the economy. Among other things, the Journal wrote, the document argues that Trump should have the power to eject Jerome Powell, the Fed chairman, well before his term ends in 2026. (Two Trump advisors told the Journal that, until such an idea was announced by authorized staffers, “no aspect of future presidential staffing or policy announcements should be deemed official.”)
The news of this document comes at a particularly resonant moment. Inflation has proven so stubbornly sticky that the Fed is looking less and less unlikely to cut rates any time soon. At one point this past winter, market observers were expecting as many as four rate cuts of 25 basis points each over the course of this year, with the first of these cuts arriving as early as May. Now, though, estimates have shrunk to two rate cuts, and it’s difficult to conceive that the earliest will be announced in July, as banks have recently been thinking.
In this juxtaposition — the political and the economic — lies an inherent conflict, as well as the reason why the Fed should preserve its independence.
A BRIEF HISTORY OF SETTING RATES
1791: The First Bank of the United States is established, with central banking responsibilities. Its charter lapsed 20 years later, after which it was revived as the Second Bank of the United States.
1913: President Woodrow Wilson signs the Federal Reserve Act into law. The Fed begins to operate in 1914.
1921: The first federal funds loans are made between New York City banks. Four years later, banks outside New York are lending federal funds locally as well.
1935: The Federal Open Market Committee is brought into being through the Banking Act, to replace an earlier, informal committee that bought and sold Treasury bonds.
1939-1948: During the Second World War, the Fed keeps the interest rate on Treasury bills steady at 0.375%, but it continued this policy even as inflation climbed to 8% after the war, in 1948. When the Fed chair, Marriner Eccles, wished to hike rates, President Harry Truman replaced him with a more pliable appointee.
1951: The Fed’s independence is restored via the Accord with the Treasury department.
1965: President Lyndon B. Johnson, having just enacted a tax cut and wanting to spend on his Great Society programs, clashes with the Fed chair William McChesney Martin Jr., who wants to hike rates to deal with inflation. “You’ve got me in a position where you can run a rapier into me and you’ve done it,” Johnson. “I just want you to know that’s a despicable thing to do.” Martin does not relent.
1979: The Fed adopts a policy of targeting M1, or the volume of nonborrowed reserves in the economy, as a means of targeting inflation.
1982: The open market committee announces that it will no longer set a specific objective for M1. Implicit in this is a reversion to targeting the federal funds rate, the approach that had existed prior to 1979.
QUOTED
The President looked wild; talked like a desperate man; fulminated with hatred against the press; took some of us to task...for not putting a gay and optimistic face on every piece of economic news, however discouraging; propounded the theory that confidence can be best generated by appearing confident and coloring, if need be, the news.
— Arthur F. Burns, former Federal Reserve chairman (on whom more below), describing the pre-Trump Trump, Richard Nixon
THE CLASH
The politician is an electoral animal. A first-term president will have their eyes on a second term. A second-term president will have their eyes on midterms, and on their party’s prospects in the next presidential campaign. And as any sixth-grader can tell you, it’s important to be popular. In economic terms, this means it’s important to minimize pain in the here and now — to let easy money flow, and to postpone the tough love of higher interest rates.
The Fed’s mandate, though, is the opposite: to crack down on any sign of overheated inflation, even if tightening rates hurts the economy and pushes it to the brink of recession. To do this, the Fed has to act immediately, without regard for the consequences for upcoming elections or other sundry popular markers.
Trump knows this, of course. It isn’t that he’s ignorant of the Fed’s mandate. Rather, he wants to do be able to do the short-term, populist thing: to bend the interest-rate regime to his immediate benefit, leaving subsequent governments to wrestle with inflation. One may agree or disagree with how the Fed views the present inflation scenario, or with its views on “acceptable” levels of unemployment. But that the Fed should make its decisions without being influenced by political objectives is inarguable.
ONE 🏦 THING
Economists who consider a co-opted Federal Reserve always have the specter of the above-mentioned Arthur F. Burns hanging over their thoughts.
Having been nominated to the post by Richard Nixon in 1968, Burns served as chair of the Fed for two terms. The appointment was a politically-angled one: Nixon wanted easy money to persist through the 1972 campaign, so as to give him the best possible shot at re-election. In 1969, though, inflation leaped to 6.9%. Other Fed chairs would have ramped up policy rates to deal with rising prices. But as the historian Allen Matusow wrote in his book “Nixon’s Economy”:
Burns had offered Nixon an implicit bargain. In 1971 Nixon controlled prices, and in 1972 Burns supplied money by the bushel. The policy helped reelect the president but also assured the next cycle of boom and bust.
Nixon won his second term, but his price and wage controls had no effect. Inflation spiralled to 12.3% in 1974, in the midst of a recession that lasted a year and a half. Eventually, it took Paul Volcker’s drastic escalation of the federal funds rate in 1980, to an all-time high of 20%, to bring inflation back down. Other factors had helped drive inflation up, of course, but the episode remains a salutary lesson in the perils of a politicized Federal Reserve.
Thanks for reading! And don’t hesitate to reach out with comments, questions, or topics you want to know more about.
Have an independent weekend!
— Samanth Subramanian, Weekend Brief editor