US president Donald Trump’s aggressive Twitter assault on the interest rate decisions of the Federal Reserve, and chairman Jay Powell in particular, represent a clear threat to the independence of the US central bank.
At his most extreme, the president has likened Mr Powell to an “enemy” of the US. This bizarre language is completely out of line with the norm among political leaders in the advanced economies since the 1990s.
We must, therefore, ask whether US monetary policy is now entering a new era, or perhaps returning to a much older one, in which the central bank is treated as the monetary wing of the White House and the Treasury.
The key questions for investors are as follows:
1. Why does central bank independence matter?
It has been clearly established by macroeconomists since the mid 1990s that independent central bankers are likely to control inflation at a lower cost in terms of output volatility than elected politicians, because the latter respond to short term electoral pressures that result in higher inflation and elevated inflation expectations
No one disputes that the ultimate authority to create money should lie with elected bodies, but there is a mountain of evidence that the operational decisions should be delegated to independent professionals, subject to ultimate economic targets set by the government. (See this speech by former Fed vice-chair Stanley Fischer for a summary).
Recently, with global inflation undesirably low, this inherent advantage of independent central banking has seemed far less important than before but it could reassert itself any time.
2. What does Mr Trump think about monetary policy?
He has been extremely inconsistent. During the 2016 election campaign, he championed higher interest rates on savings but also demanded lower interest rates to help American manufacturing companies and other borrowers.
Once elected, president Trump initially followed an unexpectedly orthodox approach. He did not press the Fed to deviate from its plans to tighten monetary policy in 2017, and his early appointments to the Federal Open Market Committee were impeccably mainstream.
When Mr Powell was nominated as chairman in November 2017, a White House official said that the president “respected and appreciated” the nominee’s extensive business background, adding that this enabled him to understand the impact of monetary policy on the economy “in a real and direct way”.
While Mr Powell was a Republican, and Mr Trump had criticised the incumbent, Democrat Janet Yellen, on the campaign trail, there were relatively few complaints that this appointment was an inappropriate use of the president’s prerogative.
3. What caused the rupture with Mr Powell?
The Trump/Powell relationship began to sour when the trade war erupted last year. Mr Trump began to argue that lower US interest rates were essential to prevent the dollar from rising against the renminbi and the euro.
Since then, he has coupled abusive tweets towards the Fed with attacks on China. As the Fed has reduced interest rates more slowly than Mr Trump urged, the volume of tweets increased. The slowing economy, and the increasing proximity of the 2020 election, have probably been the prime motivators.
4. What do the markets think?
So far, the markets have shown little concern about the “politicisation” of the Fed. One reason is that most people believe that the main problem facing the central bank is how to sustain growth, not how to ignite inflation, which remains stubbornly low.
From that perspective, Mr Trump has been pushing the Fed in the “right” direction, and may have been quicker than the FOMC to spot the downside risks to the economy in 2019. The markets would react very differently if inflation started to rise.
5. Has the Fed been affected by the tweets?
On the surface, no. The official Fed line is that it does not engage in politics, and has no jurisdiction in trade policy. The FOMC simply reacts to the economic consequences of the policies adopted by the president and congress.
On this interpretation, Mr Trump has had no direct effect on the Fed’s decision to ease monetary policy significantly in the past year. The FOMC’s central expectation for policy rates at the end of 2021 has dropped by 125 basis points since September 2018
However, there is some recent evidence that Mr Trump’s tweets coincide with a small drop in market expectations of future interest rates in the hours surrounding their appearance. It is possible that the FOMC subsequently feels pressure not to disappoint these expectations. But these effects are not large (see box).
6. What else can Mr Trump do?
He cannot force a change in the Fed’s leadership until Mr Powell’s term ends in February 2022, well after the election. If the economy weakens further, possibly in the context of further tariff increases, the Fed would certainly cut interest rates. Ironically, Mr Powell would be among the first on the FOMC to support this. But it is not the kind of monetary easing that the president has in mind.
In sum, Federal Reserve independence seems to have survived Mr Trump’s extraordinary twitter attacks rather well, so far.
Monetary policy and the twittersphere
President Trump’s official twitter account has issued several dozen tweets criticising the Fed since April 2018. The tweets have become much more frequent in recent months:
Forward expectations of US rates have fallen by 150 basis points since November 2018. According to a recent NBER paper by Francesco Bianchi et al, the average short term effect of each tweet has been to reduce forward interest rates by 0.28 basis points, implying that the effect of all the tweets has been to reduce rates by 10 basis points in total, a negligible amount.