President Trump’s undermining of the Federal Reserve’s independence could trigger a financial crisis.
It would never be a good time for the Federal Reserve to lose its monetary policy independence. However, it would be particularly inopportune for that to occur at a time when our public finances are on an unsustainable path, import tariffs are expected to add to inflation, and foreign investors are beginning to lose confidence in the dollar and the US Treasury market.
Anyone doubting that Trump intends to bring the Fed under his control has not been paying attention. Breaking with precedent, Trump repeatedly browbeats Federal Reserve Chairman Jerome Powell in public, urging him to cut interest rates. Indeed, Trump is calling on Powell now to cut interest rates by three full percentage points, even at a time when inflation remains above the Fed’s 2 percent inflation target and import tariffs are expected to add to inflation.
Worse yet, Trump is aiming to get complete control of the Fed’s board of governors and to replace Powell with a monetary policy dove who will do his bidding on interest rate policy when Powell’s term expires in May next year. Recently, Trump succeeded in getting Stephen Miran, the chair of the Council of Economic Advisors, confirmed as a Fed governor while allowing him to remain at the White House. Now he is aiming to have Lisa Cook removed from the Fed’s board on the grounds of alleged mortgage fraud. If he succeeds in that endeavor, Trump’s nominees will have a majority on the Fed’s board.
Federal Reserve independence is the most effective way to ensure that inflation expectations remain well-anchored. This is especially the case today, when the Congressional Budget Office expects the budget deficit to remain at more than 6.3 percent of GDP for as far as the eye can see, and when the public debt-to-GDP ratio will reach a Greek-like 117 percent by 2034.
A primary weakness of the US economy is that it relies heavily on foreign creditors to finance its twin budget and external current account deficits. Indeed, currently, foreign investors own approximately $8.5 trillion, or nearly one-third of all US Treasury bonds outstanding. It is imperative that the United States retain foreign confidence by not inflating its way out of the debt problem. This is especially the case at a time when the United States will need foreign creditors not only to continue rolling over their existing Treasury holdings but also to increase those holdings to finance our ballooning deficits.
There are a number of troubling signs that foreign investors are beginning to lose confidence in our commitment to keep inflation well contained. Since the start of the year, the dollar has depreciated by 11 percent, marking its worst beginning of the year performance since 1973. The dollar depreciation is all the more worrying because it has occurred at a time when the dollar might have been expected to receive a boost from high import tariffs and a widening of the short-term interest rate differential in its favor.
Meanwhile, gold prices have increased by 45 percent since the start of the year, partly due to foreign central banks shifting their international reserve holdings away from the dollar toward gold. Equally troubling is the apparent loss of the safe-haven status of US Treasury bonds at times of market volatility.
Trump ignores these market signs at his peril. If he proceeds with his plan to strip the Fed of its independence, he risks shedding foreign investor confidence in our commitment to low inflation. That could trigger both a dollar and a Treasury bond market crisis as foreign investors seek to reduce their holdings of Treasury bonds. In turn, that could precipitate a domestic financial market crisis, allowing the inflation genie to escape once again from the bottle.