Opinion: Fed threats rattle the public confidence on which the U.S. economy depends

Humans are generally forward-thinking creatures. We extend our hands to soften an impending fall. We tighten our belts when our financial future is uncertain. That humans make choices today based on our beliefs about the future has implications for all kinds of important economic questions, including the role of the Federal Reserve in the economy.

For at least the last 70 years economists have argued that central banks should set policy in a way that is independent from the political goals of the currently ruling government. This idea is often shortened to “central bank independence.”

This week President Donald Trump attempted to fire Federal Reserve Governor Lisa Cook over as-yet unsubstantiated accusations of mortgage fraud on Cook’s part. Cook has stated through an attorney that she will challenge this firing in court.

There are substantive questions about the legal framework under which Federal Reserve governors and other officials serve, illustrated in Peter Conti-Brown’s excellent book, “The Power and Independence of the Federal Reserve.” Other concerns exist in regards to whether the accusations being levied against Cook provide sufficient justification for her firing.

However, this attempt at removing Cook from her role as governor comes after months of Trump haranguing Federal Reserve Chairman Jerome Powell to lower interest rates.

Since his inauguration, Trump has called Powell “stupid”, a “numbskull,” “very dumb” and “hardheaded,” among other insults. This behavior has spooked financial markets into questioning the Federal Reserve’s ability to remain independent under the current administration as well as this administration’s commitment to lowering inflation.

That the Fed should be independent is not obvious. The cost of central bank independence includes the risk that an organization not subject to the check of the voting public through appointment by the currently ruling party could lead to a Fed that is instead subject to influence from less democratic parties like major corporations or foreign entities.

Experience has shown, however, that when politicians have control over the ability to create unbounded amounts of money through control of the central bank, they often find it hard to restrain themselves.

Since 1900, the world has seen many examples of countries that have experienced hyperinflation because the currently ruling political party wanted to print money to pay off debts, stimulate investment, or help political cronies. An incomplete list includes: Argentina, Austria, Brazil, China, Germany, Greece, Hungary, North Korea, Peru, Philippines, USSR, Venezuela, and Zimbabwe.

These periods of hyperinflation, without exception, cratered the productive capacity and economic growth of the country in question. One important reason for this is that high levels of inflation decrease the value of household savings. So much so, that households, looking into the future like they often do, find it much less advantageous to save.

Household savings, however, are the source of funds that financial intermediaries use to invest in companies that have a new product to bring to market or that would like to build a new factory or would like to develop marketing campaigns to open new markets to their products. They are, in essence, the fuel that economies use to grow. Without this important source of funding, economic growth sputters and stops.

The risk that political interests might use the power of money creation, whether through direct printing of money or through lowering of interest rates (which creates money by encouraging increases in lending) has been understood for decades.

It is this risk that has led economic orthodoxy to value central bank independence. Former Fed Chairman William McChesney Martin famously spoke of the role of the central bank in slowing down the urge to stimulate an economy toward inflation, saying the Fed’s job was “to take away the punch bowl just as the party gets going.”

The loss of Federal Reserve independence puts at risk its ability to slow down inflation when it is most needed, which puts at risk households’ incentive to save. On Monday, when Trump announced his disputed firing of Governor Cook, 10- and 30-year treasury prices fell, increasing the cost of borrowing for the United States as well as companies domiciled here. The dollar fell in value against most major currencies.

The decline in bond values and the decrease in the value of the U.S. dollar are largely attributed to decreases in the expected future value of the dollar, that is, increases in market participants’ expectations of future inflation.

But why, you might ask, did this happen so quickly? The firing of a Fed governor does not directly impact inflation, so why are bond yields rising and dollar values dropping? The answer, as it so often is in economic matters, is that a very important factor in the determination of economic outcomes is the beliefs that people have in their heads about the future.

If households think that inflation will be high, then they don’t want to pay high prices for bonds that pay back a fixed set of soon-to-be devalued dollars. As such, they pay less for those bonds and bond prices fall, causing effective bond yields to rise. This leads to higher borrowing costs for the government, which worsens tax burdens and deficits into the future.

Worse yet, if individuals are disincentivized to save because they worry that their savings will be devalued through inflation, then companies will not be able to borrow needed funds to grow, which lowers household wealth and the demand for labor. The forward-thinking nature of humans means that these outcomes can, and often do, happen long before we can actually measure the inflation about which households are worried.

For this reason, investors, businesses and economists wince at the casual name calling and threats directed at the Federal Reserve from the Trump administration. The insults levied against Powell and Cook are unkind and unwarranted, for sure. Even more worryingly, they are unwise.

On a very practical level, they put at risk American households’ confidence in the Federal Reserve’s ability to preserve the value of their savings and a decline in that confidence will have real impacts on our well-being today, as well as in the future.