Why Federal Reserve Independence Matters

Trump is threatening the independence of the Federal Reserve. But why does this even matter? And what does the Fed even do?

The role of central banks in the economy is a privileged one. They have the ability to manipulate the supply of money, and more importantly, they set the overnight interest rate that banks will lend money to each other at, which cascades into the interest rate for borrowing money across the whole economy.

The Federal Reserve has a dual mandate, which Chairman Powell stresses in every meeting: to meet target inflation and unemployment.

Generally, lowering interest rates lowers unemployment. When businesses can borrow money more cheaply, they’re more willing to expand and hire. However, this also increases inflation. Demand for labor comes with a demand for everything else, and if supply can’t meet it, prices will rise.

This was seen most dramatically when the Fed dropped interest rates to zero after the COVID pandemic. It prevented mass layoffs, but the increased demand from consumers combined with a lack of supply from pandemic-era supply chains led to record inflation.

The Fed’s decisions reverberate through the market, and a lot of money rides on predicting this. In fact, you can see exactly what the market thinks the future interest rates will be by the Fed Funds Futures curve.

CME’s FedWatch tool provides a nice visualization of this in probabilistic terms. As you can see in this graph, the market currently thinks that the Fed will continue to pause interest rate changes at the next meeting in three weeks.

This is because the Fed is conservative. The organization is composed of experts who deeply understand the impacts of their decision on the economy, and will not threaten it for short-term economic reasons, especially in times of instability.

The same cannot be said for politicians. They are motivated to keep their constituents happy in time for the next election. This biases them in favor of lowering interest rates, which will heat up the economy in the short term, even if it might cause inflation in the long term.

If the Fed has to bow to political pressure, the probabilities you see would shift dramatically to the left, since Trump has been loudly proclaiming that he wants to see interest rates cut.

Such a move would be completely unprecedented and would undermine trust in the dollar as a whole. The falling stock market, rising treasury yields, and falling dollar all imply that institutions are already seeking to exit US markets, and this would only exacerbate this process.

Do you think Trump will fire Powell? Tell me in the comments.

Read more at Bloomberg: https://lnkd.in/gBQviQzy