Concerns About the Federal Reserve’s Independence
The debate about the Federal Reserve’s independence has gained momentum following President Donald Trump’s repeated attacks, including the recent firing of Fed Governor Lisa Cook based on questionable allegations. However, this debate is too narrowly focused on the president’s political pressure and overlooks a growing danger in the system.
The Link Between Monetary and Fiscal Policy
It is true that since the Treasury-Federal Reserve Accord of 1951, the Fed has had operational independence, which allows it to set interest rates without any obligation to make government borrowing cheap. Nevertheless, the bank’s monetary policy cannot be insulated from the effect of fiscal policy, and vice versa. As public debt grows, the link between the two becomes more visible, and fiscal dominance, which occurs when a central bank like the Fed becomes subordinate to the government’s fiscal policy, looms larger.
Fiscal Dominance in Action
For instance, fiscal policy can happen in the name of financial stability, as seen in the UK in 2022. When former Prime Minister Liz Truss unveiled unfunded tax cuts and new spending, bond markets collapsed, and the Bank of England was compelled to intervene and buy long-dated bonds "on whatever scale necessary." The official justification was financial, but the underlying dynamic was fiscal dominance. The bank had to postpone inflation-fighting measures to cope with a fiscal decision. Fiscal dominance also occurs in the name of fiscal sustainability, where higher interest rates mean higher interest payments, more borrowing, and a higher deficit.
A Return to Pre-1951 Thinking
Some economists have wondered whether there was more to the Fed’s hesitation to raise interest rates when inflation took off in 2021 than a misread of the situation. The motivation for fiscal dominance was there, and it’s now being made explicit by President Trump, who is demanding lower rates on the grounds that high interest payments on government debt are "costing taxpayers trillions." This is the textbook logic of fiscal dominance and a return to the pre-1951 thinking.
A Lesson from the Past
In contrast, the 1980s offered an example of a Fed chairman refusing to submit to fiscal dominance. When Paul Volcker raised interest rates to fight inflation, he made it clear to former President Ronald Reagan that, regardless of the fiscal consequences, he would not back down. The rates would stay high for as long as necessary. Volcker even pressed Congress to do its part in fighting inflation by cutting spending. He understood the interplay between monetary policy and fiscal policy, and over time, through a series of tax increases and eventual consolidation under former President Bill Clinton, it was fiscal policy that adjusted to support disinflation.
The Current State of Affairs
Today, the arithmetic is far less forgiving, and Congress is missing in action. Our debt is more than 100% of GDP, and interest payments are rising, already absorbing nearly one-fifth of federal spending. If legislators deal with Social Security and Medicare’s insolvency through increased borrowing instead of meaningful reforms, the debt will explode. The pressure on the Fed will continue to exist, no matter who occupies the Oval Office, thanks to the fiscal trajectory that was locked in years ago and Congress’ refusal to do anything about it.
The Implications of Chronic Fiscal Stress
The implications of chronic fiscal stress are sobering. Inflation pressure is unlikely to be quelled, and it’s misleading to say that the Fed alone controls inflation. It can do so only if fiscal policy is aligned with that task. Fed independence, in a narrow political sense, becomes irrelevant when the arithmetic of debt service dictates outcomes. Without slower spending growth and real budgetary reforms, no amount of monetary maneuvering can restore stability. The question is not whether the Fed Chair will resist Trump’s demands but whether Congress will behave in a way that allows the Fed to do its job.
Conclusion
In conclusion, the concerns about the Federal Reserve’s independence are valid, but they are only part of a larger issue. The growing danger of fiscal dominance, fueled by rising public debt and Congress’ inaction, poses a significant threat to the stability of the economy. It’s time for lawmakers to take responsibility and make meaningful reforms to ensure that the Fed can do its job without being pressured by fiscal policy. Only then can we restore stability and secure a prosperous future for generations to come.
