Central bank independence is having a moment.
With inflation and unemployment likely to simultaneously increase, leading to stagflation, this is exactly the moment when one wants a central bank setting interest rates absent pressure from the political sector.
Cutting interest rates into stagflation is a recipe for higher inflation, higher interest rates, higher unemployment and slower growth, which is the worst of all worlds given the adverse supply shock that is in train across the U.S. economy.
The ability to focus on longer-term economic goals such as price stability and maximum sustainable employment creates a foundation where inflation expectations remain well anchored.
Note how in the data visualization below inflation expectations remained well anchored for 25 years until the twin shocks of the pandemic and the Ukraine war, and then, more recently, the current trade war, which is a testament to the utility of central bank independence.
With the knowledge that price stability is a precondition to maximum sustainable employment, it requires a central bank to lean toward the portion of its mandate furthest away from its target.
In addition, decades of empirical evidence illustrate that economies with greater central bank independence tend to possess lower rates of inflation and retain greater degrees of policy credibility that keep inflation expectations anchored through periods of exogenous or endogenous supply shocks.
After the past few weeks, there is simply no argument that the U.S. has not entered the initial stages of an adverse supply shock of the sort that is exactly why central bank independence is the sin qua non of keeping inflation at bay over the medium to long term.
In the case of the Federal Reserve, that means keeping its policy rate anchored in a range between 4.25% and 4.5% until it gets clarity on trade policy, the direction of inflation, and how firms will respond to higher input costs caused by the increase in tariffs.
Read more of RSM’s insights on the economy and the middle market.
This is the moment when a central bank needs to look through noise from the political sector and set policy with the intent of protecting price stability. Once the economy absorbs the policy shock, the central bank can then cut rates to obtain maximum sustainable employment based on the new equilibrium conditions.
The shock of the past few weeks has created conditions where domestic and foreign investors are de-risking and diversifying away from dollar-denominated assets.
Cutting the policy rate into conditions best described as stagflation would only intensify that movement, driving capital flows into euros, yen and francs while driving interest rates higher.
That capital flight would only make financing government operations more expensive and cause the cost of financing capital expenditures and payrolls for businesses higher. It would also raise prices for households as they finance home purchases, auto purchases and variable costs of credit.
