A little over a week ago, Donald Trump again managed to make a headline after criticizing the Federal Reserve. Reacting to the stock market correction, he blamed the Fed for raising interest rates too fast, thereby undermining the US economy. Trump claims that the Fed is “making a mistake”, and that it “has gone crazy”. But publicly criticizing the Fed is very unusual for a President to do. Why? Because the central bank is independent to protect it from political interference in monetary affairs.
The Federal Reserve, or Fed, is the system of central banks of the United States. As such, it conducts US monetary policy. Its mandate from Congress is threefold: to ensure maximum unemployment, stable prices (inflation of 2%) and moderate long-term interest rates. In order to achieve these goals, it sets a short term interest rate target, the federal funds rate. This is the rate at which banks lend each other money overnight. The Fed influences this rate through so-called Open Market Operations (OMO). This is done through trading with primary dealers, the designated banks that trade with the New York Fed. If the federal funds rate is above the Fed’s target, it will buy government bonds to increase the money supply and lower interest rates. If the rate is below target, the Fed sells bonds to contract the money supply. By steering short term interest rates, the Fed influences the cost of credit, which in turn affects consumer spending and investments.
By steering short term interest rates the Fed influences the cost of credit, which in turn affects consumer spending and investments
So, when the Fed thinks actual inflation is too low, it will lower the federal funds target rate and buy bonds from primary dealers. This lower interest rate will stimulate consumer spending and business investment, increasing aggregate demand in the economy. Due to the lower interest rate, capital will flow out of the country, thus lowering the exchange rate because of investors selling the currency. This lower exchange rate in turn stimulates the export sector and discourages imports, further increasing aggregate demand. All other circumstances remaining equal, this higher demand increases the price level in the economy. If the Fed is doing its job right, it targets the federal funds rate to the level that ultimately leads to the desired level of inflation, which in the case of the Fed is 2% annually for the medium term. It finds this level most consistent with its ultimate goals of price stability and maximum employment.
Central Bank Independence
The Fed is an independent central bank. This implies that the government does not interfere in the daily business of the bank. Congress gives the Fed its mandate, the governors of the Federal Reserve are nominated by the President and confirmed by the Senate. The central bank is then left on its own to achieve its assigned goals. This principle is known as Central Bank Independence (CBI) and is a great good. Too often have politicians taken over the central bank for political purposes. This has happened in Western countries in the past and happens at this very moment in Venezuela for example. Consequences have been disastrous. Under political pressure, central banks resort to policies that come down to printing money. You do not have to be an economic genius to understand that you cannot print your way out of trouble. However, the consequences of bad monetary policy do not show immediately. Inflation and its distortive effects on the economy show up gradually over time. That is why it’s tempting for politicians to pressure the central bank to lower interest rates or lend money to the government outright with freshly printed money. In democracies, the politicians elected will probably be out of office by the time inflation becomes so dire that it causes severe economic trouble (as witnessed in the 1970’s for example). In autocracies, the people have no say in political matters anyway, so a dictator can just order his central bank to print money without immediate political consequences. In order to prevent these sort of practices from happening, most central banks in Europe and North America are independent from the government. CBI ensures that the central bank can conduct monetary policy consistent with its main goal, which is price stability. If this principle is undermined, policy will be influenced by factors outside the economic realm and will therefore be detrimental to the economy.
Under political pressure, central banks resort to policies that come down to printing money
Why has the Fed “gone crazy”?
Donald Trump has opened fire on the Federal Reserve, saying that the Fed has gone crazy and that “they are making a mistake”. He thinks that the Fed is raising interest rates too quick and too fast. In order to understand why the Fed is raising interest rates, it is first necessary to understand why they were so low in the first place. When the economy slowed down in 2007, the Fed started to lower interest rates in order to prevent deflation from occurring. Despite this effort, economic circumstances continued to deteriorate and the Fed kept pushing interest rates down. However, at some point the interest rate reaches its zero bound and cannot be decreased further. At this point, the Fed came up with a new policy, called Quantitative Easing, or QE for short. These were several programs that consisted of massive buying of government debt and Mortgage Backed Securities in order to accommodate bank lending to consumers and businesses. In short, monetary policy after the crisis has been extraordinarily accommodative. Because of the economic recovery, the Fed has already stopped its unconventional policy of QE. Besides, it has conducted multiple rate hikes this year, with a new increase in the Federal Fund rate widely expected in December. According to most economists, this is exactly the policy the Fed should be following. Raising interest rates prevents the economy from overheating and keeps inflation in check. It also gives the Fed maneuverability to decrease interest rates again should a new recession arise. Remember there was hardly any room left for more monetary stimulus after QE. However, this is not how Trump sees it. He sees higher interest rates as a barrier to economic growth. It is thus no surprise that Trump thinks that the Fed is “making a mistake”. Besides from the fact that most esteemed economists disagree with Trumps monetary views, the President undermines the sound principle of Central Bank Independence. And that is his newest stupidity.
There was hardly any room left for more monetary stimulus after QE
Can Trump fire the Fed Chairman?
Given Trump’s history with firing people it is not unreasonable to ask whether Trump can actually fire the Chairman of the Federal Reserve, Jerome “Jay” Powell. Powell was appointed by Trump in February of this year. The current path of tightening monetary policy was widely expected and exactly what the Fed has been doing. However, the recent stock market correction was reason for Trump to publicly question the Fed’s policy. In a recent Bloomberg interview Trump said he would not fire Jay Powell. However, even if he wanted to fire Powell, this would prove to be a highly difficult job. The position of the Fed Chair is protected by Central Bank Independence. The chairman can only be fired for severe crimes. A different view on monetary policy can thus not be a reason to fire Powell.
The position of the Fed Chair is protected by Central Bank Independence
The reason that central banks are independent is to prevent politicians from influencing monetary policy for political gain. Undermining its independence, which is what Trump does by publicly criticizing it, must be taken as a warning. If Trump continues to undermine the Fed’s independence or would somehow manage to fire Powell, monetary policy and by extension the economy would be in severe danger. Hopefully Trump will not be “making a mistake” himself again.