Institute Insights: A Federal Reserve Declaration of Independence
By Kenan Institute Director of Research and UNC Kenan-Flagler Business School Richard Levin Distinguished Professor of Finance Christian Lundblad
For the first time since the tumult of the global financial crisis, the Federal Reserve lowered interest rates by 25 basis points on July 31. The decision was controversial along a multitude of dimensions. First, the technocratic argument for the commencement of an easing cycle is not unambiguous. Second, the communication coming from various Fed officials both before and after the meeting left a lot to be desired; market participants have struggled to digest the messaging. Finally, the interest rate cut followed a consistent stream of criticism emanating from President Trump’s Twitter handle, looking rather like a capitulation to political pressure. Whether in actuality or not, the Fed’s decision-making feels somewhat less operationally independent. But before I dig into that highly lamentable political reality, let’s review the “here and now” so as to gauge where things might be headed.
Given that consumer confidence and U.S. economic growth are solid and the unemployment rate is effectively at record lows, the argument for a rate cut is not obvious. Nevertheless, well-meaning economists and business leaders can disagree on the trajectory of the U.S. economy and the degree to which storm clouds are brewing. Further, weak growth in Europe and China, coupled with the clear negative effects of the trade war, have definitely affected the prospects for components of the U.S. economy going forward. For example, the most recent GDP print shows relatively weak capital investment despite the tax benefits touted by the Tax Cuts and Jobs Act. A possible culprit is a significant degree of paralysis associated with trade war uncertainty – and the events of the last week certainly haven’t helped there. Given these challenges, one could make an argument for a pre-emptive rate cut to help soften the blow of any external impediments.
Even if you appreciate the importance of an early course correction, it has to be acknowledged that the messaging has been poor. What Fed officials haven’t done well, either before or after the decision, is manage expectations through their communications efforts. A few weeks ago, we had a speech from the head of the New York Fed that was widely taken to suggest that the Fed might aggressively cut by 50 basis points in the upcoming meeting. This inference was then uncharacteristically walked back by a subsequent press release, and the movements in the closely-watched Federal Funds futures market were stunning. In addition, the post-meeting press conference by the Fed Chair did not give much additional clarity about the reasoning for the policy shift nor the roadmap going forward. The Chairman’s interaction with the financial press, suggesting that the rate cut was perhaps a one-off, generally confused market participants. The press coverage over the remainder of the day was rather amusing (if it weren’t so serious). Going forward, the same Federal Funds futures markets are predicting several additional cuts before the end of this calendar year, but it will be very important for Fed officials to do a markedly better job managing their communications.
Despite my skepticism over the technocratic argument for a rate cut and my obvious frustration with the poor messaging, these largely reflect typical complaints among the punditry and are, hence, in the spirit of calling balls and strikes. We can disagree with the umpire, but we continue to play the game under the established rules. However, far more seriously, political influence cannot be part of the process by which monetary authorities operate. This is not about balls and strikes, but rather a concern about a dangerous challenge to the very rules of the game. There is a distressing movement in our country that directly challenges or delegitimizes various arbiters tasked, to continue the metaphor, with enforcing rules. Whatever post-crisis forces are behind this wide-ranging skepticism, it has now started to bleed into Fed independence. To be clear, the Federal Reserve should (and does) face oversight from elected leaders through the nominating process, but the actual technocratic, day-to-day process of managing monetary policy has been largely operationally independent. This is a positive situation and is backed by the historical record.
In a now-famous paper from 1993, Alberto Alesina and Larry Summers, using data from around the world, showed that central bank independence promotes price stability; inflationary pressures mount, on average, in those countries where central banks are influenced by government leaders. To varying degrees, numerous research endeavors have since corroborated this finding. As a result, the importance of central bank day-to-day operational independence was, despite the presence of some well-known skeptics, the near-universally received wisdom. In response, many central banks over the years were granted greater degrees of autonomy.
However, it also should be noted that the financial crises was – like for so many other widely held beliefs about economic policy – a watershed moment undercutting the popular confidence in the merits of Fed independence. For the first time in a long time, heated questions were raised about the Fed and the relatively secretive group of unelected technocrats that held such power over the trajectory of the U.S. economy and hence her citizenry. In particular, many fumed over the possible role the Fed played in promoting the financial excesses that engendered the eventual explosion. Others questioned the merits of the ensuing unconventional crisis responses: the zero interest-rate policy, unprecedented promises made to market participants, trillions of dollars in quantitative easing and the virtual alphabet soup of other market backstops. Fed skeptics finally had their day. Those who generally sat on the fringes complaining about the unconstitutionality of the Fed were joined by a collection of average Americans wondering what exactly the Fed was doing, with whom were they in league and to whom were they really responding.
At a purely factual level, it is fair to acknowledge that there is no mention in the U.S. Constitution of such a group of unelected technocrats tasked with these responsibilities. Indeed, I suspect several of our founders would look at such an institution with skepticism. Even leaving that aside, there is long-standing philosophical disagreement about the general efficacy of central bank intervention. Some are so certain that a group of technocrats is unable to consistently get policy right that they would prefer that the money supply be controlled by market forces (or tied to physical assets, like gold) rather than be subject to flawed discretionary stabilization policy. They view the outsized unintended consequences as too problematic. Others are in vehement opposition to this view – arguing that if we have a tool to help suffering Americans, we ought to use it. To do otherwise would be “barbaric,” in the words of Keynes. These are fascinating, age-old philosophical debates, but at some level they truly are academic because we have a Fed. Given that we have a central bank tasked with discretionary monetary policy, macro and micro risk monitoring and mitigation, and the like, we’d better have an independent Fed that approaches these responsibilities with rigor, free from the short-term whims of various leaders. We can certainly recommend a healthy dose of humility, but technocratic rigor is first order.
As I’ve already mentioned, well-meaning people can read the tea leaves quite differently about the current roadmap for the U.S. and global economies. Those most worried about an impending slowdown would actually superficially appear to be on the same side as our current president as he asks (tweets, harangues, etc.) for a more accommodative policy. However, it is critical that we not confuse the technocratic argument for a rate cut with a politically-motivated juicing of the economy. If the Fed is going to pursue a series of interest rate cuts going forward, we need to believe it is because they are trying to manage emerging macroeconomic challenges in keeping with their mandates. A central bank’s greatest asset is its credibility. The alternative danger is that by granting an elevated role to an elected leadership (from any party or faction) in monetary policy determination, we may realize exactly the greatest fears of the Fed skeptics. If the central bank becomes an arm of the political machinery, we sow the seeds for a general debasing of the U.S. currency. Simply put, if we have a Fed, and we do, it must be operationally independent.