E-Paper
Get Ready for the End of Fed Independence
Markets haven’t yet grappled with the implications of the president having control over the central bank.
The market response to President Trump’s Monday attempt to fire a Federal Reserve governor was relatively calm.
Don’t let that fool you. If Trump’s effort to remove Lisa Cook for cause succeeds, and perhaps even if it doesn’t, this week will go down as one of the most consequential for financial markets in decades.
It could mark the end of the Federal Reserve’s independence from White House control, which it effectively obtained in 1951. As a result, inflation is likely to be higher and more volatile than in the decades before 2020.
Investors aren’t yet pricing such a scenario. In part that’s because the Fed was already preparing to cut rates. On Friday, chair Jerome Powell indicated that tariffs were unlikely to lead to sustained inflation given a weak labor market, opening the door to a rate cut in September. In the near term, that should boost stock prices and bring down bond yields.
More importantly, investors have no historical template for a politicized Fed, and assume its leaders under Trump will behave as they have under previous presidents, setting interest rates according to the economic data and their forecast.
Investors would be wiser to assume that starting sometime in the next nine months, the Fed will set rates according to Trump’s preferences.
Lisa Cook being sworn in in 2023.
This is the logical conclusion based on the lengths Trump has now shown he will go to gain control of the Fed. In the central bank’s 111-year history, no president has tried to remove a governor. As investment bank Evercore ISI said in a note to clients Tuesday: “Asset markets are not properly priced for what increasingly seems likely to be a rupture in Fed independence.”
In seeking to remove Cook, Trump cited allegations of mortgage fraud which are serious. But Cook hadn’t even had a chance to respond to the allegations before Trump demanded last Wednesday that she resign. On Monday he said she was fired, though she hadn’t been charged, much less convicted. Cook said Trump has no authority to fire her and would go to court to stop him.
Trump’s strategy with the Fed, as with tariffs, is like boiling a frog: moving gradually enough to lull markets into thinking nothing of macroeconomic significance has happened. When he announced steep tariffs in early April, markets revolted so he walked them back. Then, piece by piece, he restored most of them, and markets took it in stride.
Similarly, when he mused about firing Powell last month, markets were roiled. So instead of trying to remove Powell, Trump has looked for a way to accomplish the same thing. If he replaces Cook, he will have appointed four of the Fed’s seven governors.
“We’ll have a majority very shortly. Once we have a majority, housing is gonna swing and it’s gonna be great,” Trump said Tuesday.
Trump-appointed governors wouldn’t necessarily control the Fed’s decisions immediately, because five of the 12 members of the rate-setting Federal Open Market Committee are presidents of the reserve banks. But the board has authority over those presidents, and could force any or all of them out of office by early next year.
Removing bank presidents would be an unprecedented violation of norms. But Trump has demonstrated repeatedly he is willing to violate norms.
“This is a tail risk more than a base case,” said economist Peter Williams of investment research firm 22V in a note to clients. But it “could have the most impact on policy by potentially removing important dissenting, whether formally or just verbally, voices from the FOMC.”
Once confirmed, Fed governors are in theory free to vote on interest rates as they wish. But by seeking to sack Cook for cause, Trump has signaled that he could do the same for any sitting governor who doesn’t vote as he prefers on interest rates.
If courts rule the president gets to define cause, it would nullify the protection the Supreme Court said Fed governors have. Even if Trump loses, he may well try again, and his next target may choose to change his vote or quit rather than fight.
Trump has also gone to much greater lengths now than in his first term to ensure that his appointees are loyal.
Typically, candidates for the Fed, like candidates for federal judgeships, don’t preview how they will rule once in office. That convention has gone out the window. Trump’s Fed candidates have generally said they think rates should go down even though inflation, at around 3%, is still above the Fed’s 2% target.
Last September while Joe Biden was still president, Stephen Miran, then an investment fund strategist, said it was a mistake for the Fed to cut rates with underlying inflation between 2.5% and 3%. Now chairman of Trump’s Council of Economic Advisers and a candidate for a spot on the Fed and with rates are a full point lower and underlying inflation the same, he has echoed Trump’s criticism that the Fed has been slow to lower rates. He argues Trump’s policies will deliver lower inflation.
Last week David Malpass, a former president of the World Bank who is also under consideration for a spot, wrote in the Journal that the Fed should cut interest rates and anchor itself “in forward-looking, market-based data with a goal of defending the dollar.” But the dollar has fallen steadily this year, which in Malpass’s framework would typically be an argument against cutting rates.
In the short term, inflation will be determined by economic conditions, not the makeup of the Fed. Right now, inflation-protected Treasury bonds see a bump in inflation in the coming year because of tariffs, then returning close to the Fed’s target.
Markets aren’t good at pricing structural shifts in the economy. They didn’t anticipate the high inflation of the 1970s, its collapse in the 1980s under then-Chairman Paul Volcker, the housing and mortgage crisis of 2007-09 or the pandemic inflation of 2021-22. An investor can lose a lot of money betting on something that happens so rarely.
Still, investors might want to prepare for a coming structural shift on inflation. Williams of 22V ticked off the major macroeconomic policies now at work: the highest tariffs since the Great Depression, stimulative fiscal policy, a stagnant labor force, and sustained assaults on the independence of the Fed. “It seems like an environment just right for above-target inflation.”
Write to Greg Ip at greg.ip@wsj.com
