Trump's attacks on the Fed are worse than you think

ANOTHER VIEW

The Federal Reserve's political independence- the sense that the world's most powerful central bank makes decisions based on economic conditions, not short-term political considerations - is a critical national asset. President Donald Trump is eroding it in ways that could be bad for the country and his own agenda.

For months, Trump has demanded that the Fed lower interest rates, with no success. Now, the administration's attacks on Chair Jerome H. Powell are escalating: White House budget adviser Russell Vought blasted Powell on social media for "grossly" mismanaging the Fed, and Federal Housing Finance Agency Director William J. Pulte accused him of lying under oath during recent congressional testimony. And on Monday, Trump called Powell "a knucklehead" and a "stupid guy" who is costing the United States a significant amount of money.

If Trump fires Powell - an unlikely outcome - immediate disaster would result: Investors would lose confidence in the Fed's ability to make politically tough but economically necessary decisions. Investors would abandon U.S. assets, bond markets would go haywire, and the dollar would plummet.

But Trump risks politicizing the Fed even if he lets Powell stay through the end of his term as chair in May. He has signaled that Powell's successor must be willing to cut rates to get the job, which means that markets will perceive any nominee - whether Scott Bessent, Kevin Warsh, Kevin Hassett or someone else - as pre-politicized.

That would bring bad economic consequences, even in the best-case scenario.

Suppose the new chair, unwilling to totally compromise his legacy, refuses to sharply cut rates like Trump wants.

Instead, he delivers just a quarter-point cut - a concession to political pressure, perhaps, but a small one.

The market reaction would still be swift. Investors would immediately assume that the cut was a product of political pressure, not economic data, and start to worry that the Fed would not be tough enough to fight inflation if it ticked up again. Investors might anticipate a higher steady state of inflation- at 3 or 4 percent, for example, rather than the Fed's 2 percent target.

Recent data gives reason to worry. In June, consumer prices rose 2.7 percent on an annual basis, up from 2.4 percent in May, indicating that Trump's tariffs are starting to trickle throughout the economy.

Beliefs about future prices - known as inflation "expectations" - can strongly influence actual prices. If people believe prices will increase, they will choose to spend rather than save, so their money doesn't lose value sitting in the bank. Businesses, budgeting for the future, might preemptively raise prices or agree to higher wage contracts.

More spending puts upward pressure on prices, which in turn increases inflation expectations, initiating a dangerous cycle. And the Fed - now more responsive to Trump's pressure - might be unwilling to raise interest rates aggressively enough to stop it.

Plus, even if Trump gets exactly what he wants - a Fed chair willing to vote for rate cuts on command - a short-term economic boost might not materialize.

A more dogmatic Fed chair is more likely to lose the confidence of the other 11 members on the Federal Open Market Committee, the group that sets interest rates and guides monetary policy. To protect the Fed's credibility, the rest of the committee might vote against the chair and decide to keep rates high even when conditions could reasonably warrant a cut. As a result, the Fed might actually cut rates less often to avoid further tarnishing its reputation.

Rate cuts also help growth only if borrowing increases. But household consumption and business investment aren't affected by the interest rate that the Fed sets directly. Rather, most big loans - mortgages, auto loans and so on - are tied to longer-term Treasury yields. Normally, when the Fed cuts its short-term policy rate, those longer-term rates fall, too. (Rather than park funds at the Fed to earn a now-lower rate, banks would rather lend to their customers.

That reduces the cost of credit, pushing rates down.)

But if investors believe the Fed is lowering rates for political reasons, they might become more concerned about inflation and demand higher yields on long-term bonds to make up for the chance of future inflation eating into their returns.

That's what happened in Turkey amid its inflation crisis. From August 2021 to January 2022, the central bank of Turkey cut its benchmark interest rate from 19 percent to 14 percent. Over the same period, yields on 10-year Turkish bonds increased from 17 percent to 23 percent.

Investors, so concerned about Turkey's irresponsible monetary policy, demanded higher compensation for holding the government's debt - undermining the central bank's attempts to lower borrowing costs.

Politicians aren't good at monetary policy. They face a powerful temptation to goose the economy in the short term, even at the cost of future growth. (Just look at how Trump's budget bill will explode the national debt.) That's why independent central banks exist: to take the long view and make decisions based on economic fundamentals rather than the political calendar.

Trump threatens to destroy that independence. If the next chair pledges allegiance to Trump's economic preferences, future presidents might demand the same loyalty of their appointees, too.

A permanent loss of Federal Reserve credibility would not just be a problem for rich investors; American families would also feel the pain.

- The Washington Post