Interest Rate Cuts and Federal Reserve Independence

Lately, President Trump has been pressuring Federal Reserve chairman Jerome Powell to cut interest rates. This has set off concerns about Federal Reserve independence. And reasonably so. Generally speaking, the more independent the central bank is from political pressure, the better the country’s economy performs on monetary measures like inflation (interested readers can find a survey of the literature here). Indeed, the Banking Act of 1935 significantly changed the Federal Reserve’s structure to make it more independent from the Executive branch, and Congress in general.

To be fair, Trump isn’t the only one trying to reduce Federal Reserve independence. Libertarian-leaning folks also call for reduced Fed independence with slogans like “Audit the Fed!”

But how much influence would an individual president have over Federal Reserve monetary policy? Probably not much.

Monetary policy is determined by the Federal Open Market Committee (FOMC), a 12-person committee made up of the 7 members of the Fed’s Board of Governors, the president of the Federal Reserve Bank’s New York branch, and 4 rotating Federal Reserve Bank presidents from other branches. Of these 12 members, only the Board of Governors are appointed by the President (and confirmed by the Senate) to 14-year terms. Of the current members (Jerome Powell, Philip Jefferson, Michelle Bowman, Michael Barr, Lisa Cook, Adriana Kugler, Christopher Waller), only one has a term expiring during this Trump administration (Adriana Kugler). Powell’s term as chairman expires, but he remains on the board until his 14-year term is up. Assuming each individual serves out their entire term, Trump could only appoint one person to this 12-member committee. Even if this person is a puppet, one vote does not a majority make. Even if one wants to include the three current members appointed by Trump in his first term, that still only means 4 votes out of 12.

Now, readers will notice a problem in that last sentence. “Jon, you sly and handsome devil,” I hear you cry, “These are 14-year terms. How could Trump have appointed 3 people in his first term?” Not all Fed governors stay for their whole term. These are some of the most in-demand people in the finance world. A 14-year term represents a huge opportunity cost for them in terms of foregone salary from other alternatives. Many quit before their term is up to take jobs elsewhere.

Let us assume, for the sake of conversation, that all 7 on the board resign before their terms are up and a president can appoint (and get confirmed) all 7 new members who will follow lock-step with whatever he wants. In that (extraordinarily unlikely) scenario, it is possible the president will be able to manipulate monetary policy.

However, as Jason Furman (former CEA head under Obama and current Harvard professor) reminds us, the Federal Reserve is not a central planner, strictly speaking:

President Trump’s focus on a Fed Chair who will slash rates is misguided even on his own terms:

1. The Fed Chair is 1 of 12 votes, a political hack Chair won’t get majority

2. Even if FFR slashed the rates people care about, like mortgage, could go up w/ higher expected inflation

The Federal Reserve only sets a handful of interest rates, and those are limited to rates between banks—the discount rate (the rate at which banks can borrow from the Fed) and the interest rate it pays on bank reserves at the Fed. The Fed tries to influence the Federal Funds Rate (the rate at which banks borrow from each other) through FOMC operations, but they do not set that rate.

The actual rates you and I see are still determined by market factors: risk, inflation, supply, demand, etc. The Fed cannot set interest rates for mortgages, credit cards, and so on. It does not have that power. It tries to influence those rates, yes, but it does not set them.

So, even if a president were able to fully manipulate monetary policy, it is not likely to lead to the outcomes they want. If Federal Reserve interest rates are unjustifiably lowered, commercial banks will anticipate more inflation, leading to higher nominal interest rates charged to consumers. If a president is upset by this (predictable) turn of events, threats of price controls and other “solutions” could follow, making a bad situation even worse.

Concerns over Federal Reserve independence are legitimate, but a lot of things would need to go wrong for it to lose its independence.