Fed independence may be the next major loser

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“I respect his independence,” former President Nixon reassured the White House crowd at the 1970 swearing-in of Fed Chair Arthur Burns.

“However, I hope that independently he will conclude that my views are the ones that should be followed.”

There’s no video of the event, so it’s hard to say for sure, but I’m guessing that was meant as a joke.

It’s also exactly how things worked out.

Burns famously allowed Fed policy to become subservient to Nixon’s political goals, fueling the 1970s epidemic of inflation.

The much-maligned Fed chair reportedly acknowledged this as a tactical surrender: “We dare not exercise our independence for fear of losing it.”

Subsequent Fed chairs have fought their corner more resolutely, stressing that the Federal Reserve is an independent agency within government.

“Our independence is a matter of law,” Jerome Powell said just last week.

But that plain statement may mean less than it sounds.

Specifically, Powell meant that individual members of the FOMC are insulated from politics because they can’t be fired: “We’re not removable except for cause,” he noted. “We serve very long terms.” 

(“Seemingly endless terms,” he added, drawing a laugh from the sympathetic crowd.)

This, he says, allows the FOMC to do its job “strictly without consideration of political or any other extraneous factors.”

“We’re never going to be influenced by any political pressure,” he promised.

If so, that would be a new development.

For the first two decades of its existence, political influence on the Fed was explicit: By law, the treasury secretary automatically served as the chair of the Federal Reserve as well.

That changed in 1935 as the Fed gained a measure of independence with the chair becoming a presidential appointee, no longer tied to the Treasury Department.

In 1951, the Fed won a further degree of independence when the Treasury Department formally agreed that the Fed could set interest rates without its input.

Still, this hard-won independence remained contingent on political approval.

The Fed was established by an Act of Congress and Congress retains the ability to revise the Act if it disapproves of how its creation is operating.

This is why, at his final press conference as Fed chair, Ben Bernanke offered a simple piece of advice to his successor, Janet Yellen: “Congress is our boss.”

It’s been a reluctant boss, for the most part — after delegating its Constitutional power over money to the Fed, Congress has generally only held the Fed accountable after financial disasters.

Often, the Congressional response to those disasters is to grant the Fed more power, not less.

This is by design.

In The Myth of Independence, Sarah Binder and Mark Spindel explain that, whatever Fed chairs like to say, the Federal Reserve is actually “interdependent” with Congress — and that Congress retains the ultimate authority through the Federal Reserve Act and its power to revise it.

The Fed, they explain, is dependent on Congress for its authority and Congress is dependent on the Fed for its stewardship of the economy.

This arrangement works for Congress largely because it gives them someone to blame when things go wrong — Binder and Spindel note that former Fed Chair William Martin once testified in Congress that “we’re here to be blamed.”

The result, they say, is that the Fed is “acutely sensitive to the need to secure political support for its policy choices.”

Similarly, the monetary economist James Dorn found that “the Fed is independent, but in practice that independence is continuously tested by political pressures for using accommodative monetary policy and credit allocation to win votes.”

It’s mostly been presidents who’ve exerted that political pressure.

Truman called William Martin a “traitor”; LBJ summoned the long-serving Martin to his Texas ranch to verbally assault him over interest rates; Burns was famously subservient to Nixon; Carter reassigned former Fed Chair William Miller to the Treasury Department because interest rates were too low; Paul Volcker was able to raise rates to 20% only because he had Reagan’s backing.

Dorn’s study found all this presidential pressure to be effective: “An examination of the evidence reveals that presidents tend to get the monetary policy they desire,” he concluded.

As a matter of principle, that may not be the worst thing — we wouldn’t let unelected bureaucrats set tax rates without political recourse, so why should we let Fed bureaucrats set interest rates?

As a matter of practice, however, it hasn’t worked out well.

In a study of presidential influence on the Fed, the economist Thomas Drechsel unsurprisingly found that political pressure increases inflation “strongly and persistently.”

Specifically, he concluded that “increasing political pressure by half as much as Nixon, for six months, raises the price level more than 8% after a decade.”

Drechsel also found that presidential pressure to lower interest rates negatively affects GDP.

The effect is mild, but he cites it as evidence that “political pressure is not successful” for presidents hoping to win votes by raising economic activity. 

That hasn’t stopped them from trying, of course, as we were reminded this week.

Does publicly calling Chair Powell a “major loser” amount to half as much political pressure as Nixon applied on former Chair Burns? 

If so, history suggests we have an 8% increase to the price level to look forward to.

Or does President Trump’s schoolyard name calling amount to, say, twice as much pressure? 

Drechsel doesn’t do the math on that because, before this week, who could have imagined a president exerting twice as much pressure on a Fed chair than Nixon did with Burns?

But investors appear to be doing the math for themselves: Bitcoin ETFs took in $381 million yesterday — a notable reversal of the recent trend.

That’s helped push the price of bitcoin to near an all-time high relative to the S&P 500 — a surprisingly sensible reaction to renewed presidential pressure on a Fed chair.

When former President Nixon swore in Chair Burns in 1970, gold traded at $35 an ounce.

When President Carter swore in Chair Volcker in 1979, it was about $300 and on its way to a high of $850 a year later.

Markets seem to sense the Fed has another tough decade ahead of it — one spent fighting for its independence.

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