Beyond a mere change at the top

This photo shows the Federal Reserve Building on Constitution Avenue in Washington. Photograph: J. Scott Applewhite/ AP Photo/ picture alliance

Trump could alter the face of the US central bank, explains Kerstin Bernoth.

The genie is out of the bottle. Donald Trump is now president-elect of the United States, but the end of a long and difficult campaign has not put political uncertainty entirely to rest. One area under close scrutiny will be the course of monetary policy of the US Federal Reserve System in the upcoming months and years. Trump has hinted at two changes he may seek, both of which could strongly mould the central bank’s – and the economy’s – course in that time. Trump has in the past criticised the Federal Reserve’s current chair, Janet Yellen, for keeping interest rates too low for too long, suggesting he may replace her when her term ends a year after he takes office. In addition, he and other Republicans have suggested altering how the Federal Reserve is audited, possibly subjecting it to Congressional review, a change that could erode its characteristic independence and subject its decision-making process to politics.

With inflation continuously above the two percent target since November 2015 and unemployment levels having halved since October 2009 to around five percent, the Federal Reserve cautiously started to exit its extraordinary expansionary monetary policy stance in December 2015, increasing key interest rates by 25 basis points to a new target range of 25-50 basis points. Further monetary tightening is expected in the coming months, but the question is when and how exactly this will happen, and at what speed. All these decisions will have tremendous impact not only on the recovery and financial stability of the US economy, but on the world economy as a whole.

On first view, one would assume the election result will not affect such monetary policy decisions, since in the end the Federal Reserve operates, like many other central banks, independently of the government. The primary justification for central bank independence is the need to insulate monetary policy from short-term, election-focused political pressures. The Fed’s monetary decisions do not have to be ratified by the president or any other member of the government, it receives no funding from Congress, and members of the Board of Governors are appointed for fourteen years, in order to delink their terms from the electoral cycle. The Fed is allowed to set monetary policy without political interference, but must in turn report and explain its decisions to Congress twice a year and has to demonstrate that it is meeting its mandate.

Under the current legislation, the president nevertheless shapes monetary policy by appointing the Federal Reserve Board chair from among the members of the Board of Governors. The current chair is Janet Yellen, whose term ends beginning February 2018. That means Donald Trump will need to figure out within a year of entering the White House whether he wants to keep Yellen for another four years or not. However, Janet Yellen is closely associated with the Democrats, and Trump is a Republican. This per se does not seem to be a compelling reason to replace her. There often have been Republican Fed chairs under a Democratic presidency and vice versa. A good example is the Republican Alan Greenspan, who was reappointed chairman five times; three times by Republican presidents and twice by the Democratic president Bill Clinton.

But Donald Trump already announced in April this year that it is unlikely he will reappoint Janet Yellen. This was confirmed once more the day after the election, when Judy Shelton, a member of Trump’s advisory team, reiterated that the new government is seeking to put in a new chair when her term ends in early 2018. Their reason: she kept official interest rates too low for too long, creating a “false economy”.[1]

Trump’s criticism of Yellen suggests he will seek a chairperson who will follow a more hawkish monetary policy course in the future, i.e. higher interest rates. However, during his election campaign Trump also stated he plans to increase infrastructure spending and cut taxes across all income levels. This suggests that the Republican presidency aims for a fiscal- rather than monetary-driven recovery of the economy. In principle, this idea is not wrong. Monetary policy can help to smooth the business cycle and – to some extent – cushion downswings, but it cannot promote long-term potential growth. It is rather fiscal and economic policy that matters in this respect. However, with a government debt ratio of more than 100 percent of gross domestic product (GDP), the US does not have much capacity for fiscal stimulus. Moreover, interest service on outstanding US government bonds will rise in parallel with monetary tightening, exerting additional fiscal pressure. Asked how he would deal with the high national debt level, Donald Trump said in May that the US never has to default on debt “because you print the money”.[2] This statement stands in contrast to his criticism that the Fed’s monetary policy under Janet Yellen has been too loose in the past.

Thus, a high degree of uncertainty prevails concerning the future course of US monetary policy under a new Republican Fed chair. The reaction of Fed Funds futures rates on the day after the electionhowever, indicated that financial analysts did not adjust their expectations for key interest rates in the next couple of months or quarters. Only the intra-day volatility of Fed Funds futures prices increased, reflecting financial market uncertainty only on that day.

Presidential appointments may not be the only uncertainty facing the Federal Reserve. Several Republicans, including Donald Trump, have repeatedly advocated for all of the Fed’s actions to be audited by the Government Accountability Office (GAO), in an attempt to increase transparency. This would also include individual monetary policy decisions, which would make them subject to Congressional review.

The question of the optimal degree of central bank independence and accountability is not a new one. One faces here a classic cost-benefit trade-off. On the one hand, the demand for transparency and public accountability increases, the more independent a central bank is to assure that monetary policy is being conducted in the national interest. On the other hand, more central bank auditing raises the risk that members of Congress apply political pressure on the Fed.

The Federal Reserve already has a high degree of transparency. Its biannual testimonies to Congress are only the tip of the iceberg. In practice, the Fed’s public communication about policy takes many more forms, i.e. the publication of detailed minutes of its eight regular Federal Open Market Committee (FOMC) meetings in which interest rates are decided, its quarterly economic forecasts, regular press conferences, board member speeches etc.  Inserting the Congress and the GAO into monetary policy decisions would call the Fed’s independence into question. The fact that the election put both the House of Representatives and the Senate under Republican control has made it much easier to change the Federal Reserve legislation, which is more than worrisome.

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