Keep Trump, and Every Other President, Out of the Fed
If a central bank has to exist, it has to be independent.
The main job of a central bank is to maintain the purchasing power of the currency, yet the U.S. dollar has depreciated about 97 percent since the Federal Reserve was created in 1913. The Fed has done a profoundly bad job, especially in recent history. Having 19 unelected bureaucrats in charge of the most important price in the economy—the price of money—is a bad idea. If the Federal Reserve were abolished tomorrow, the markets would do a serviceable job of determining the path of short-term interest rates and allocating capital efficiently.
But we're stuck with the Fed for now. To the extent a central bank is necessary, you want it to be free from political influence. Studies show a strong negative correlation between central bank independence and the rate of inflation. The more independent a central bank is, the more likely it will be willing to do the hard thing and raise interest rates to stop inflation. When politicians have influence over the central bank, invariably, there is pressure to lower interest rates because it speeds up the economy and reduces unemployment—things that politicians like. But as you can see from a couple of contemporary examples (like Turkey and Argentina before President Javier Milei took office) political influence on monetary policy is a very bad thing.
Enter Donald Trump, who wants to have direct influence over monetary policy. You might recall that he spent most of his first term haranguing Fed Chairman Jerome Powell (whom Trump nominated in November 2017) to lower the federal funds interest rate to zero or negative. Trump is looking at this from the perspective of someone who is a real estate developer and borrows a lot of money. Naturally, he wants lower interest rates. He also thinks people should be able to buy cars and houses with easy money. Prior to the election, Trump's team was circulating some ideas on how to constrain the Fed's monetary policy authority, up to and including giving the president himself a seat at the Federal Open Market Committee. Trump has had some bad ideas in the past, but this is the most alarming and arguably the worst.
Economists look at this in terms of real interest rates. The real interest rate is the nominal interest rate (the actual rate) minus the rate of inflation. At the moment, the nominal interest rate is 4.5 percent, and inflation is currently at 2.9 percent, so the real rate of interest is 1.6 percent. Real rates have mostly averaged between 1 percent and 2 percent throughout history. When they are low, monetary policy is loose, and when they are high, it is restrictive. But in the 2010s and early 2020s, we had negative real interest rates, where the nominal interest rate (usually at zero) was below the rate of inflation. Negative real interest rates caused asset prices to rise, like stocks and real estate, and as a result, stocks and real estate are now unaffordable. That long period of negative real interest rates was also partly responsible for the great inflation of a few years ago. If the market were in charge of setting interest rates in 2010, they would have been materially higher, and we would not have experienced the inflation or asset price distortions that we did.
The bonkers part about all of this is that there are some prominent intellectuals on the right who think that giving Trump some power to set interest rates is actually a good idea. Luminaries such as Stephen Moore and Art Laffer have openly criticized the Federal Reserve's rate hikes to stop inflation during the last rate hike campaign in 2018, with Laffer preferring some involvement from the executive branch. Moore was actually floated as a potential member of the Fed's Board of Governors but withdrew under bipartisan opposition. The Fed is very protective of its independence, and for all of Biden's faults, he almost never commented on monetary policy during his tenure. It should be pointed out that political donations from Fed employees skew heavily Democratic, and it is possible Trump thinks they will try to undermine his presidency.
Powell is on his second term as Fed chairman, expiring in 2026. Powell has stated he will not resign if asked to by Trump. While Trump has said he will not move to replace Powell, it seems unlikely he will wait until 2026 to try to make changes at the Federal Reserve, though it's unclear what he might try. The danger is that Trump appoints a factotum to be Fed chairman in 2026, and subsequently, the Fed as an institution will do his bidding.
If Trump is successful, expect a return of high inflation in the second half of his term, and the dollar, which is extraordinarily strong right now, will weaken significantly. If interest rates are held below equilibrium, housing prices will appreciate even faster than they have in the past four years, which will benefit current homeowners at the expense of potential homeowners.
As Milei's experience in Argentina has taught us, we should all be naturally suspicious of the motivations of the central bank—but giving the president the ability to set interest rates is not the answer.
