Financial stability requires an independent Fed

[WASHINGTON, DC] When US President Richard Nixon appointed Arthur Burns as Federal Reserve chair in 1970, he welcomed him to the job with these words: “I respect his independence. However, I hope that, independently, he will conclude that my views are the ones that should be followed.”

Nixon’s views were that the economy needed “lower interest rates and more money”, presumably in part because this would help his re-election bid in 1972. And Burns did fall into line, more or less. But the consequences were unfortunate: Fed policy contributed to high inflation, which reached a dangerous and disruptive level by the end of the decade. It took prolonged high interest rates and a deep recession for the Fed to bring inflation back under control.

Tensions between central banks and governments are nothing new – and this includes friction between the Federal Reserve System and the president of the United States. Presidents typically want to boost economic growth and want monetary policy to support this goal with lower interest rates. Central bankers, however, also bear responsibility for maintaining price stability and worry that overstimulating the economy for short-term purposes will end in tears.

In recent weeks, President Donald Trump has been pressing the Fed to lower short-term interest rates, to help the economy weather the coming storm from higher tariffs and other trade-related disruptions. But, because tariffs raise the price of imported goods, they tend to raise the price level and create the potential for further price increases. Whether the Fed should cut rates remains to be seen, and Fed chair Jerome Powell and his colleagues are wise to want more data.

How big a hit will the US take to gross domestic product? And how much of an upward shock to inflation is the economy about to encounter? The uncertainties surrounding the Trump administration’s policies make these key variables difficult to predict.

In this situation, cutting short-term interest rates could prove counter-productive, because the Fed cannot control long-term rates, such as on 10-year government bonds. If financial markets think that inflation will increase, interest rates will tend to rise on long-term government debt, pulling up long-term interest rates for all potential borrowers across the economy – which will further depress business investment and make it more expensive to buy homes.

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In the language of central banks, economic growth, job creation, and financial stability are all helped when expectations for annual inflation remain anchored at around 2 per cent. Given the experience during and after the pandemic, these expectations are already under pressure. It would be unwise to allow inflation to surge in the near future.

Big movements in long-term interest rates can easily cause problems for financial stability. Liz Truss’ short-lived government in the United Kingdom learned this the hard way in October 2022. The last thing that the US and other economies need now is disruption to bond markets, banks, insurance companies, hedge funds, or any large financial company or activity.

Trump seems to have backed down from his recent threats to fire Powell – a detente that, assuming it holds, should help soothe financial markets for a while. But Powell’s term expires in May 2026, and by the end of this year, market participants will want to know what happens next. The president appoints all members of the Fed Board of Governors, including the chair, subject to confirmation by the Senate, and it is entirely within presidents’ authority to pick people they think will be accommodating as policymakers – as Nixon did.

The Trump administration has already asserted and achieved an unprecedented degree of centralised control over the executive branch – meaning that all regulatory decisions, no matter how consequential, need approval from the very top. In the February executive order that effectively ended the independence of federal agencies, the administration also claimed complete control over all measures by the Fed other than those regarding monetary policy. This is already a concern, because many regulatory decisions, for example, on bank reserves (held on the asset side of banks’ balance sheets) and bank capital (the equity required for banks’ liability side), are fundamental to financial stability and therefore to the conduct of monetary policy.

But that expansive February executive order wisely left monetary policy to be decided by the central bank, its appointed officials, and its deep well of experts, who base their decisions on the mandate given to them by Congress. If the administration at any point reverses course and undermines those thoughtful professionals, removes them “for cause”, or otherwise encroaches on their independence, we will all, sooner or later, pay a cost – and perhaps a very high one. PROJECT SYNDICATE

The writers are co-chairs of the CFA Institute Systemic Risk Council.

Simon Johnson, a 2024 Nobel laureate in economics and a former chief economist at the International Monetary Fund, is a professor at the MIT Sloan School of Management and the co-author (with Daron Acemoglu) of Power and Progress: Our Thousand-Year Struggle Over Technology and Prosperity (PublicAffairs, 2023). Erkki Liikanen, a former governor of the Bank of Finland, is chair of the IFRS Foundation Board of Trustees and chair of the Board of Bruegel.