Preserve the Fed’s Independence above All Else

With higher-than-normal inflation and an administration dead-set on massive spending measures, the independence of the Federal Reserve is of vital importance. Fed chairman Jerome Powell’s term expires in February 2022, and President Biden can either renominate Powell to another term or choose a replacement. When making that decision, he’d be wise to keep the central bank’s independence at the front of his mind.

The wisdom of central-bank independence becomes clear when you understand the confluence of incentives and time that goes into making monetary policy. Central banks control the money supply, which means they have a lot of power to influence economic outcomes. They can pursue expansionary policies to boost growth and reduce unemployment in the short term, but doing so brings a risk of inflation down the road. And since politicians love to brag about the strength of the economy on their watch, no matter what that strength means for long-term economic prospects, it’s in a country’s best interests to keep the central bank as insulated from electoral politics as possible.

A 1977 paper by economists Finn Kydland and Ed Prescott used a lot of technical economics to make a straightforward point: Policy changes often backfire because people are forward-looking. Even if policymakers are competent and well-informed at the time that they take a particular action, people are not particles in an experiment; they will adjust their behavior and expectations in response, which can in turn lead the action to have unintended long-term effects. Using that insight, Kydland and Prescott demonstrated that unconstrained, discretionary monetary policy leads to higher inflation. Their paper so revolutionized economics that they won the Nobel Prize in 2004.

We know from international comparisons that central-bank independence is one effective means of preventing high inflation. An influential 1993 paper by economists Alberto Alesina and Lawrence Summers looked at 16 highly developed countries and found an extremely strong correlation between central-bank independence and low inflation. Countries with central banks that lacked independence — e.g., Spain, Italy, and New Zealand — had high average inflation. Countries with central banks insulated from politics — e.g., Germany, Switzerland, and the U.S. — had low average inflation. Alesina and Summers also found that central-bank independence had no effect on economic performance, so the low inflation didn’t come at the cost of high unemployment.

Nailing down causality is difficult, and other factors, such as a country’s political culture and its citizens’ attitudes toward inflation, matter too. But the examples of countries whose central banks have transitioned from political control to independence are compelling. With monetary policy under the direction of politicians, New Zealand had erratic inflation throughout the ’70s and ’80s, averaging about 12 percent and ranging from 3 to 18 percent. It made its central bank independent in 1989, and from 1991 to today, it’s averaged 2 percent inflation and hardly ever exceeded 5 percent.

Central bankers have become more effective due to the accumulated lessons of past successes and failures, according to Boston College economics professor Peter Ireland. “They developed a better understanding about how inflation could be stabilized by a policy that, even if it didn’t follow a mechanical rule, it is rule-like in the sense that it is systematic and predictable. All of that learning process has led to better outcomes,” Ireland tells National Review.

The catch is that even economies with an independent central bank don’t sink or swim on monetary policy alone. When the U.S. economy thrived from the late ’80s to the early ’00s, for instance, it had other factors working in its favor, among them a significantly less-polarized politics. “It’s easy to do the right thing when everything is going well,” Ireland says. “Now, the question is can they keep doing the right thing when times are tough.”

Jerome Powell has proven himself to be immune to political pressure. Powell was nominated to the Fed Board of Governors by Barack Obama in 2011, and then nominated to chair the board by Donald Trump in 2017. That alone is a mark of Powell’s independence: He stayed at the Fed and earned a promotion even as the presidency changed parties. But despite his survival, the concerns of electoral politics have still started to encroach on his turf. Trump attacked Powell repeatedly, going so far as to write on Twitter that “China is not our problem, the Federal Reserve is!” And though Joe Biden has not done the same since he took office, other members of his party have. The “squad” of progressive members of Congress has demanded that Powell not be renominated, and Elizabeth Warren called him “dangerous” during a Senate hearing while promising to vote against him if he is renominated.

Powell seems blissfully unaffected by all of this. “The bedrock of independence is how much the people at the helm of these institutions care about their public and professional reputation for delivering their mandate over the medium term,” Sir Paul Tucker, a former deputy governor of the Bank of England and the author of the book Unelected Power, tells NR. By all accounts, Powell takes great pride in the Federal Reserve as an institution, and he values being a good central banker more than being praised by politicians.

Powell is also independent in another sense: He’s not an economist. His college degrees are in politics and law, and he was an investment banker and worked in the Department of the Treasury before joining the Fed. His non-economist background might make him less susceptible to the academic fads and entrenched schools of thought that plague much of macroeconomics. “He can act more like a referee between the teams rather than representing one of the teams,” George Mason University economics professor Garett Jones says.

Powell’s lack of academic economics training doesn’t mean he’s unqualified for the job, of course. In fact, he might even have an advantage, according to Hoover Institution economist John Cochrane. “He deeply understands the complex and somewhat zany models that his staff and academics use,” Cochrane says of Powell. “He also understands their faults and limitations, and where they do and do not readily apply to the real world. . . . The breadth and depth of understanding I have seen [from him] exceeds that of many academics who spend their lives pushing equations around and cannot quite see the forest for those trees.”

There are other smart, independent people out there that Biden could nominate for Fed chair. None of the characteristics that make Powell a good choice is unique to him. But why take that risk right now, when people are on edge about inflation and trust in institutions such as the Fed is dangerously low?

“Part of what we worry about with central-bank policy is whether the central bank will create a problem that it needs to stimulate the economy to solve, thereby pushing inflation up,” Jones says. “If people think that every five years, they’re going to screw something up, then step on the gas as a result, that’s bad news.” Powell has been able to avoid that, Jones says, by keeping everyone’s expectations in check through deft communication.

Expectations can matter more than reality when it comes to monetary policy. If people believe prices will be significantly higher in the future, they will buy more in the present, which increases aggregate demand and causes inflation. “If Jerome Powell is replaced by a new Fed chair who is seen to be more dovish [on inflation], that may well trigger an increase in inflationary expectations that would in turn limit the Fed’s ability to use monetary policy effectively to lower unemployment,” Ireland says.

Tucker takes a longer view. “While I want greater resilience in the financial system, I think there’s a cost to making the Federal Reserve chair look like something that lasts only four years, and whoever’s in power gets their woman or their man. This is not a time in the history of the world to take risks with that,” he says. “Politicizing the Federal Reserve would be a gift to Beijing. [The U.S. dollar] is part of the basis for your role in the world. You make it part of partisan politics at your peril and at the peril of the rest of the free world, quite frankly.”

Recalling his work for the Bank of England at the time that it became independent in the late ’90s, Tucker adds that there’s a certain attitude an independent central bank needs to operate with: “Our time horizon in these discussions must be longer than the longest possible career of the youngest person in the room. So even if they become governor, we have to think beyond that. This is not about us.”

President Biden should be thinking along the same lines when he nominates the next Fed chair. The decision is not about him or his political party. The Federal Reserve is one of the only globally respected institutions in the United States at the moment, and it’s globally respected because of its independence. All four economists interviewed for this story expressed reservations about particular policy decisions Powell has made, and he’s certainly not infallible. But this much is beyond dispute: He understands the gravity of his job, and he takes central-bank independence seriously. Right now, this country — and the free world it leads — could use someone like that atop the Fed.