A contentious debate around the independence of the Federal Reserve has escalated in recent weeks as central bankers fall under mounting political pressure to cut interest rates.
It is reasonable to ask why central bankers and economists are so sensitive about the Fed’s independence. Their role in recent decades, after all, has been to set optimal interest rates for the economy free of political pressure.
But it wasn’t always this way. Arthur Burns, for example, the Fed chair from 1970 to 1978, cut interest rates under pressure from President Nixon. The result was the era of galloping inflation that took years of painful measures to wring out of the economy.
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Today, the sum of all fears among central bankers and economists can in large part be traced to the mistakes of that era.
Inflation in the Burns era was fueled by monetary and fiscal policy working at odds with each other during a time of large policy errors like excessive government spending and price controls. The twin oil shocks of the 1970s only worsened the problem.
The result was years of anemic growth, high unemployment and stagnant wages.
Today’s economy bears some resemblance to that era, even if the circumstances and economic shocks—like the pandemic—are different.
Although the causes of the inflation between 1965 and 1985 are quite different from the shutting down of supply chains in 2020 and the fiscal support put forward in the past two administrations, one should not ignore the possibility that fiscal dominance will not further erode the Fed’s independence and require lower interest rates to support policies of the fiscal authority.
The risk is that monetary policy becomes subordinate to the financing needs of the economy, a dynamic known as fiscal dominance. It raises the risk that inflation could turn higher as consumers and investors price in lower interest rates and factor in the lost credibility of the Fed.
Should fiscal dominance become the operational framework for monetary policy, economists and central bankers fear that the nation’s rising debt burden will lead to debt monetization and eventually to higher inflation. That would then require sky-high interest rates, elevated unemployment and a deep recession to kill off the inflation, as in 1980.
The case of Arthur Burns
Burns’s tenure at the Fed has become a cautionary tale for central bankers.
Burns acquiesced to President Nixon’s pressure to reduce interest rates in pursuit of his re-election in 1972. The result was unrestrained inflation that peaked at 14.8% in March 1980.
To re-establish price stability, it required a new Fed chair, Paul Volcker, who jacked up rates to a high of 19% in 1981, which pushed unemployment to a high of 10.67% in December 1982 and caused the double-dip recessions of 1980 and 1982.
The takeaway
One should not underestimate what an erosion in the independence of the Federal Reserve would mean for the American economy. The possible rise of fiscal dominance should not be discounted. If that occurs, then the door is open to debt monetization, higher inflation and a direct strategy to reduce the real value of U.S. debt servicing costs.
All one has to do is to take a look at the example of Burns to ascertain the risks around reducing the degrees of freedom of the Fed to set interest rates, free of political pressure.
