No self-respecting central banker can be seen as yielding to pressure from a politician facing a difficult election. A central bank that appears subservient to political concerns will rapidly lose credibility in the markets, resulting in increases in inflation expectations and rising long-term interest rates. As those of us at the Treasury Department used to remind White House political staff during the Clinton administration: Fed bashing is a fool’s game — the Fed doesn’t cut short rates, and the market raises long-term rates. The sense that policy is being politicized increases uncertainty, which is likely to decrease investment and ultimately slow growth.
So Trump is surely making a serious error in his rhetorical approach to the Fed. Two questions remain. First, how rapidly should the Fed raise interest rates in coming months? Second, recognizing that public Fed bashing is wrong, what should be the nature of relations between the central bank and the executive branch? On neither question does orthodox thinking seem quite right to me.
On the first question, it seems there is considerably more danger of the Fed raising rates too fast than too slowly over the next year. Inevitably, monetary policy is a judgment about competing risks. If the Fed raises rates too slowly, inflation will increase and remain clearly above the 2 percent target for a significant interval. This does not seem like it should be a dominant worry. Inflation has been below the target level for a decade, so above-target inflation is necessary if inflation over the long term is to average 2 percent.
Even with good luck and good policy, a recession will come along at some point and pull down the inflation rate. Two months ago, it might have been reasonable to worry about complacency in asset markets, but in light of recent volatility, this seems a lower-order problem.
On the other hand, the risks of excessive tightening seem substantial. Monetary policies affect the real economy with lags of a year or more. It is, therefore, easy for policy to tighten past the point at which the economy is thrown toward recession because of an absence of clear signals of slowing. Indeed, on almost every occasion in the past 50 years when the Fed has tightened in a sustained way, the result has been recession. The risks of a downturn now are greater than at any point in living memory because, given the zero lower bound on interest rates, the Fed would have limited room for easing, and because of the populist and protectionist pressures that would almost certainly accompany a downturn. Caution should be the order of the day.
Second, there is a need for pragmatism regarding the independence of central banks. It is important they resist the kind of pressure for inflationary policy that Trump has recently engaged in. But it is foolish to suppose that a nation’s financial policies should be conducted entirely independently of its elected officials.
Consider some examples: During the period of quantitative easing following the financial crisis, the Treasury was pursuing a strategy of extending the duration of U.S. government debt. At the same time, to pursue stimulus, the Fed was operating in the opposite direction, in effect, issuing short-term debt and buying long-term debt. Surely a coordinated policy would have reduced transaction costs and served the public interest?
Or take exchange rates, which are objects of international diplomacy and are determined, in substantial part, by monetary and reserve management policies. Should elected governments with responsibility for foreign affairs have to be removed from exchange-rate policy in the service of central bank independence?
Occasions when interest rates are constrained by a zero or near-zero floor are likely to recur in the future. In such circumstances, coordination of fiscal and monetary policies may be necessary. This is very difficult if central bank policy is entirely independent of budget policy.
The point is not that central banks should be made more subject to political pressure. That is Trump’s bad idea. It is that, as their activities expand beyond pure monetary policy, there will be a need for coordination between the banks and elected government.