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President Donald Trump gestures with Jerome Powell, his nominee to become chairman of the U.S. Federal Reserve at the Whit...

Why the Federal Reserve must remain above political influence

Editor’s note: This analysis is being published in collaboration with EconoFact, a nonpartisan economic publication.

President Donald Trump advocated Friday for the Federal Reserve to further lower interest rates.

The Federal Reserve dropped its key interest rate in July for the first time in a decade, and is expected to cut rates by another quarter point when it meets later this month.

Trump tweeted Friday, “the Fed should lower rates. They were WAY too early to raise, and Way too late to cut.”

The president has repeatedly questioned the Federal Reserve’s monetary policy decisions and encouraged rate cuts as a way to boost economic growth, despite robust job growth and near record-low unemployment.

The push from Trump highlights the larger question of the Federal Reserve’s independence from political influence. Here’s why that matters:

The issue

The Federal Reserve walks a tight balance between maintaining low unemployment and preventing the economy from heating up and unleashing inflation. Its decisions impact groups differently: raising interest rates can be painful for borrowers and businesses seeking to invest and expand; lowering them can hurt savers and those who depend on fixed income.

The independence of the Federal Reserve helps to ensure that it can make politically difficult decisions that are in the long-run best interest of the economy, just as the independence of the judiciary branch helps ensure adherence to the rule of law, even when those decisions are politically unpopular.

But this independence does not make the Federal Reserve immune to threats from the executive branch or Congress.

The facts

  • A body of economic research, both theoretical and empirical, shows that economies perform better under central banks that are more independent. To illustrate this, the chart below shows the relationship between central bank independence (using a recently developed indicator) and average inflation for 19 countries over the period 1980 to 2000. Among these advanced economies, average inflation is significantly lower in countries with more independent central banks.
  • The Federal Reserve, like many other central banks, is separate from the executive, legislative and judiciary branches of government. The Board of Governors of the Federal Reserve consists of seven members who, along with the President of the Federal Reserve Bank of New York and a rotating set of four other Presidents of the regional Federal Reserve banks, set monetary policy in the Federal Open Market Committee meetings held every six weeks. The members of the Board of Governors, except for the Chair and Vice Chair, serve fourteen-year terms and the term of the Chair begins in the middle of a President’s four-year term, in order to insulate the Chair, the Vice Chair, and the members from political pressure.
  • The Federal Reserve sets interest rate policy and also has a role in regulating and supervising the financial system. Its policy is meant to achieve its dual mandate of price stability and low unemployment. The decisions of the Federal Reserve have an important impact on the economy and, through this channel, the political climate. For this reason, politicians may want to influence the decisions of the Federal Reserve. For example, incumbents would like a stronger economy going into an election. The most famous case of this in the United States is Richard Nixon’s efforts to influence Fed Chairman Arthur Burns to stimulate the economy in order to promote his re-election in 1972. Fed policy was, in fact, stimulative in the pre-election period, only to strongly reverse course afterwards in an effort to stamp out inflationary pressures exacerbated by the stimulus.

The takeaway

There is a debate in economics on whether monetary policy should be conducted based on rules (where the central bank automatically responds in a preset way to economic conditions) or in a more discretionary manner (that allows varied responses to current events). But there is no debate that policy conducted for political ends, attempting to favor one political party or another, damages the economy.

Such a politically-influenced policy would increase uncertainty, cause the economy to go through fits and starts, and in general be destabilizing and corrosive.

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