Central bank independence

Good afternoon from New Economy Brief.

US President Donald Trump has spent the summer attacking the Federal Reserve – America’s central banking system. He’s accused the Fed’s Chair of failing to reduce interest rates fast enough, tried (unsuccessfully) to fire a Fed board member, then installed his own economic adviser on the board. The independence of the USA’s central bank is under sustained threat, with senior central bankers warning that Trump’s behaviour endangers the stability of the global economy. 

In this week’s New Economy Brief, we reflect on the recent challenges to the Federal Reserve’s independence from the Trump administration, and their broader implications for central banking – including whether the current approach is fit for purpose. 

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Warning signs at the Federal Reserve.

In recent months, the Federal Reserve has been under mounting pressure from the Trump administration. The President has repeatedly criticised Fed Chair Jerome Powell, attacking his decisions on interest rates and accusing him of stopping people buying houses. Trump’s attempts to influence the Federal Reserve risks undermining its reputation for independent decision-making. 

Although a Federal judge recently stopped Trump firing Federal Reserve board member Lisa Cook, it’s since been confirmed that the Chair of his Council of Economic Advisers, Stephen Miran, will soon join her on the board. Miran is one of the chief architects of Trump’s controversial global tariffs and champions an activist approach to monetary policy. He’s also the first White House official to join the Fed Board since the creation of the modern institution.

Trump’s actions are raising alarm bells. Senior figures in other leading central banks have expressed concerns about the consequences of a loss of trust in the Fed, with ECB head Christine Lagarde calling this  a “very serious danger for the U.S. …and the world economy.” Trump has a long, contradictory track record of doubting the Fed’s independence, claiming interest rates are kept too low during Democrat presidencies and too high during Republican ones. Taken far enough, Trump’s attacks could transform the global financial system, effectively weaponising the power of the Federal Reserve to serve his political agenda.‍

Dollar dominance could decline. If the world loses faith in the Federal Reserve, the implications could be huge, due to the centrality of the US dollar and US-led institutions within global financial flows. Asian and Middle Eastern investors are already pulling back from the US, with some even demanding depository accounts with non-US banks (deterred partly by the pressure on the Fed, but also risks of further tariffs and escalating trade war).

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Is central bank independence hitting its limits?

Trump is upending the decades-long status quo of dedication to the principle of central bank independence. In the UK, the Bank of England (BoE), not the Chancellor, has had the power to set interest rates since 1997 — handed over by an incoming Labour government five days after election. But while we may rightly challenge Trump’s motives, the theory of independent monetary policy has increasingly struggled with real economic crises. 

Giving with one hand, taking with the other. Many governments responded to the 2008 global financial crisis with fiscal austerity, pulling billions of pounds out of the economy with public spending cuts. Central banks simultaneously embarked on Quantitative Easing (QE) programmes that pumped billions of pounds into the economy: by pushing up bond prices, bringing down long term interest rates, and encouraging people to spend more, the Bank of England aimed to support the economy and increase inflation to the 2% target. However, this loose monetary policy “pushed up asset prices, including house prices, and combined with tight fiscal policy and terrible earnings growth to entrench an advantage for an older, wealthier generation”, according to the Institute for Fiscal Studies. 

The combination of loose monetary policy and tight fiscal policy has caused rising inequality. The BoE’s own analysis showed that the wealthiest 10% of households got £350,000 wealthier during QE’s first five years of QE, over 100 times more than the poorest 10%. Meanwhile lower-income households were much more likely to suffer from austerity fiscal policies like benefits cuts.  

Coordination has worked before. The COVID-19 pandemic saw much greater monetary-fiscal coordination, with the government increasing borrowing to fund emergency measures to support the economy while the BoE started a new round of QE – its value neatly matching the new borrowing. This kept interest on government debt at all-time lows, despite massive spending increases. 

However, political commitment to central bank independence remained firm: the Bank later began unwinding QE, effectively re-applying the pressure to the government’s finances it had previously alleviated. With some bond market pressure to tighten fiscal policy, former Monetary Policy Committee (MPC) members and others are raising concerns that losses on unwinding QE (around £22 billion a year, according to IPPR) are putting government finances under too much strain. They argue the Bank should slow or stop the sale of government bonds to ease the pressure on long-term gilt yields and open up more fiscal space.

The real limits of central bank independence are now being exposed, with some calling its benefits into question. It’s a good time to reflect on the current arrangement’s successes and failures, and the possible advantages of a more coordinated approach.

Underinvestment in essential services.

‍The water industry illustrates many of the UK’s economic problems. In the latest exchange of letters between the BoE and the government, the former’s Governor Andrew Bailey identified rising household water costs as a key driver of inflation. Water companies are hiking prices to make up for years of underinvestment in infrastructure, and utility bills contribute to the headline inflation figure. In July, the long-awaited Independent Water Commission – led by former Bank of England Deputy Governor Sir Jon Cunliffe – recommended a range of measures for reform, receiving mixed reactions from campaigners and unions. They support plans for a new empowered water regulator, but also want public investment and renationalisation. 

Conventional monetary policy won’t work. Part of the standard rationale for holding interest rates high is that it deters private sector investment, cooling the economy and bringing down price inflation. But the current price hike for water is caused by under-investment, so the Bank of England continuing to hold the base interest rate at 4% does little to stop water prices rising and driving inflation. Furthermore, the increased fiscal constraint as QE is unwound makes it harder to mobilise public funds and close this investment gap. 

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The problem with relying on interest rates to tackle supply-side inflation.

External supply shocks are increasingly driving inflation in the UK, and conventional monetary policy hasn't dealt well with this shift. Dr. Swati Dhingra, an external MPC member, has commented that coordination of monetary and fiscal policy instruments is “essential” in the face of external supply shocks, noting that “in a turbulent world, our macroeconomic framework will best support output growth and price stability if monetary policy works in concert with fiscal policy in certain respects". 

Better monetary and fiscal coordination. As NEF notes, “the role of central banks in the economy is not fixed; it evolves in response to changing contexts and new challenges.” With the right institutional framework, we could still enjoy the benefits of independence while better aligning monetary policy with both democratically determined fiscal priorities and with the need to address risks from climate change and geopolitical instability.