Comment: What if the Fed loses its independence?

U.S. President Donald Trump is pressuring Federal Reserve Chairman Jay Powell to cut interest rates, even though the Fed is, by law, an independent entity free from political influence. Next year, Trump will get to appoint a new Fed chair when Powell's term ends. A central bank under the president’s thumb would not restore the market’s waning confidence in U.S. politics. One might ask: Is the U.S. “on the road to Zimbabwe”?

Trump wants low rates, the Fed wants to appear independent

Powell, whom Trump appointed as Fed chair in 2018, commented last week that the central bank is caught between a rock and a hard place in the trade war. The Fed’s dual mandate is to maintain inflation at a 2% annual rate and to support employment as strongly as possible without jeopardizing the inflation target. Tariffs are a form of taxation that increases inflation. However, there are no clear signs of economic or employment deterioration to justify a rate cut yet. Trump, on the other hand, ranted on his “social truth” platform that rates should be cut immediately, that “the Fed is always late and wrong,” and that “Powell’s term will end soon,” loosely quoted. On the other hand yesterday Trump backtracked a bit when he said he has “no intention” of firing Powell.

Trump may very well be right that rate cuts would help counter the economic downturn sparked by his trade war. But a preemptive cut would appear problematic from the Fed’s perspective, signaling a lack of independence. The Fed’s decisions should be based on economic needs, not political agendas. Ironically, Trump’s comments may prompt even greater caution from Powell. In addition to its dual mandate, the Fed must also consider the global credibility of the U.S. dollar. A cautionary tale of a president-controlled central bank can be found in Turkey, where the central bank has cut interest rates even while inflation soared to 80% annually and the Turkish lira collapsed.

The Fed’s independence has always been questionable

Trump’s attack on the Fed’s independence is not unprecedented. His second term has been characterized by power centralization and placing loyalists in key positions. Independent-minded Jay Powell, ready to defend his position in court, is an annoying wrinkle from Trump’s perspective.

Historically, the Fed, established in 1913, has had a spotty record of independence. While today’s observers may see central bank independence as sacred, history shows varying roles. For example, from the 1930s to 1950s, the Fed was heavily influenced by the Treasury, keeping interest rates low to fight the Great Depression and later to finance WWII affordably. Perhaps the most famous example was Fed Chair Arthur Burns under Nixon in the 1970s, who kept monetary policy loose despite ballooning deficits and surging inflation. The modern era of strong Fed independence is best represented by Paul Volcker, who ignored political pressure while smoking his cigar and hiked rates sharply in the 1980s.

So what if the Fed loses its independence? Is Trump “revving the engine” or “cutting the brakes”?

In other words, history is full of examples of the Fed being subordinate to the administration or its chair doing the president’s bidding. So the phenomenon wouldn’t be historically dramatic or even new. Next year, a new Fed chair sympathetic to Trump (perhaps Kevin Warsh) will likely take the helm.

For politicians with grand plans for their nation, a subordinate central bank is a convenient tool. Large projects like industrialization (e.g., USSR’s universal central bank), military build-ups (e.g., Nazi Germany’s Reichsbank), or welfare state expansions (e.g., U.S. in the 1960s) require massive funding. Demand for money raises its cost—interest rates. A central bank that keeps rates low or suppresses yields (as seen in recent years in Japan) is a politician’s best friend.

All spring, I’ve been wondering whether Trump—who barks about streamlining government—is a pro-growth or anti-growth president. Despite dramatic cuts, DOGE cuts have been largely cosmetic, with federal spending rising this year compared to prior years. Moreover, Trump is pushing pro-growth measures like tax cuts and deregulation. Even the trade war, in part, aims to restore U.S. manufacturing, which requires massive corporate investments. If money is expensive, this industrial revival won’t happen. So I’ve concluded that Trump is a “run it hot” president. That means pursuing growth despite short-term disruption from the trade war, regardless of the inflation it causes.

Trump is the workers’ president. Predictable inflation and yields pleasing to bondholders benefit the coastal cosmopolitan financial elite. In contrast, a booming economy benefits truckers hauling goods in the Midwest, or steelworkers. Who cares about “a little” inflation if the trucker earns more than Wall Street analysts?

Famed economist John Maynard Keynes once quoted Lenin saying the best way to destroy capitalism is to debauch the currency through runaway inflation. Though high inflation, full employment, and a hot economy may sound cheerful, an unindependent central bank may end up directly financing government spending—leading to hyperinflation, like Zimbabwe.

The Fed doesn’t do this yet, but its massive Treasury holdings place it under pressure. In fact, the Congressional Budget Office predicted in January that the Fed’s balance sheet will grow this year. The Fed must already buy some of the debt from the market, indirectly helping the government with its funding costs. The federal deficit is already over 7% of GDP despite growth cycle, with no end in sight.

Losing Fed independence doesn’t have to lead to Zimbabwe, but the risk is real

Even if it doesn’t go as far as Zimbabwe, trust in the dollar and U.S. finances would likely erode further if Fed independence collapses. Who would trust a currency whose value is backed by a toothless institution? The skyrocketing price of gold and weakening dollar are symptoms of this trend.

Runaway inflation and cheap money aren’t necessarily good for U.S. stocks. Many investors have been shown overly optimistic takes on equities’ inflation resilience. 2022 was a good reminder: inflation shocked investors, and stocks tanked. In the 1970s, inflation ravaged stocks so badly that by the 1980s, they were seen as a dead asset class—only crazies like Warren Buffett touched them.

High inflation is bad for stocks because companies struggle to maintain profitability. U.S. firms’ return on equity (ROE) hovers just below 20%. With 0% inflation, that’s a real 20% return. At 10% inflation, real ROE is just 10%! Buffett illustrated this in his 1970s-1980s shareholder letters. Think of equity as a bond, and ROE as the bond’s yield. Everyone gets that high inflation is bad for bonds. A 5% yield is great in 0% inflation, but awful in 10%. Corporate ROE is surprisingly stable long-term, making it functionally similar to a fixed-rate bond.

In the late 70s and early 80s, U.S. stocks traded at P/E ratios of 7–8x earnings. Wild inflation crushes valuations.

Inflation is like a tax on profits (taxes are paid on nominal profits, so inflation worsens their effect). Returns on capital tend to fall too, since companies can’t always pass rising costs to customers. On top of that, investors demand higher returns (inflation brings volatility and uncertainty), and companies face rising investment costs (just look at the growing budgets of Finnish firms like UPM or Neste).

Still, in extreme inflation, stocks may perform decently after the initial shock. Turkey’s stock market has septupled in lira terms since spring 2021, and even in stable euro terms, it’s up 50%. In other words, Turkish investors have somewhat preserved their purchasing power in the stock market, even as the lira has collapsed by 80% against the euro.

Contrary to recent beliefs, the U.S. is not the only investment option (“TINA” – There Is No Alternative – used to be the norm). The rest of the world, especially the eurozone, may appear surprisingly stable compared to an America knowingly devaluing its currency. While similar budget pressures from aging populations and defense spending affect most countries, cash can be a good short-term investment as assets reprice in an inflationary world. But in the long run, gold, commodities, and stocks of companies with pricing power offer a haven for investor wealth.