The Real Threat to Fed Independence

Kevin Warsh will be sworn in today as chairman of the Federal Reserve. The question obsessing Fed watchers and political pundits is whether he will uphold the central bank’s independence in the face of intense political pressure, as did fellow Donald Trump appointee Jay Powell, the outgoing chairman, or cave to the president by cutting rates to juice the economy and let inflation run hot.

Bond markets seem to be betting on higher inflation and a less independent Fed, but I’m of the view that Warsh could be the best thing for Fed independence since Paul Volcker.

In January, I was invited to testify before the House Committee on Financial Services about the Fed’s balance sheet. Initially, it seemed like it would be a wonky hearing on a decidedly unsexy subject. A few days before the hearing, however, news broke that the Department of Justice had opened a criminal investigation against Powell. The charges—relating to a Federal Reserve building renovation project and Powell’s testimony to Congress about it—were petty, ridiculous, and seemed intended to intimidate the chairman into cutting rates.

The news injected significant drama into the proceeding. California Representative Maxine Waters opened her questioning with a statement: “I would love to engage with you about the balance sheet, [but] we should not be talking about anything but the independence of the Fed.” In fact, almost every question, from both Republicans and Democrats, started with a statement about the importance of Fed independence.

I had two thoughts: on the one hand, the drama showed that support for Fed independence has never been more robust; on the other, if everyone were really so concerned about Fed independence, the balance sheet would be a much bigger concern than anything Trump is doing.

Fed independence is critical to sound monetary policy. Stable and low inflation today depends on people believing that it will be stable and low in the future. Central bankers can cut rates to fuel the economy quickly, but running the economy hot can eventually cause inflation to rise. If they allow it to rise, then it becomes the expectation, which makes it even harder to lower it.

Politicians and central bankers face different risk profiles. The politicians are often willing to trade short-term gain for long-term inflation because they face short election cycles. But freeing central bankers from immediate political considerations enables them to weigh the long- and short-term costs and benefits of monetary policy. This independence adds to their credibility, which helps set expectations that inflation will remain low in the future.

Like many presidents before him, Trump wants lower interest rates to goose the economy in the short term. It’s not unusual for presidents to pressure or criticize central bankers, but Trump’s campaign against Powell was more overt than normal.

Still, it is the job of central bankers to resist political pressure, and Powell did that. In April, the Department of Justice dropped its case against him. The episode demonstrated that Fed independence is alive and well. The outcome may have not been Trump’s intent, but the Fed’s resistance to his pressure demonstrates its strength as an institution. Now there should be no doubt that the Fed is, at the least, no less independent than it was under Joe Biden.

That’s not to say that the Fed is as independent as it should be.  Previous chairmen, especially Powell, undermined the institution’s independence for years by taking on political objectives outside the bounds of monetary policy and by expanding the size and scope of its balance sheet. The assets held by the Fed increased exponentially since the 2007–2008 financial crisis. At the end of 2007, Fed assets totaled about $885 billion; at their peak in 2022, they were nearly $9 trillion. Today, they are about $6.7 trillion, after a period of quantitative tightening—that is, of not buying more debt. The central bank ended this practice last year when it started to grow the balance sheet again to address liquidity issues in the debt market.  

This approach represents a change in how the Fed conducts monetary policy. Before 2008, the Fed set monetary policy by steering the Fed funds rate—the overnight rate at which banks lend to each other to meet their reserve requirements. The shift occurred during the financial crisis, when the central bank was desperate to stimulate the economy and rates dropped to near zero. The Fed started paying interest on reserves so that banks parked more money at the Fed rather than lend to one another. The Fed used those reserves to buy more long-dated assets like Treasury bonds and mortgage-backed securities, with the hope of stimulating those markets.

This was a major change for monetary policy and debt markets. First, it essentially ended interbank lending, since banks had more reason to keep their reserves at the Fed, and since borrowing from other banks became a signal of financial weakness. The Fed also became a large, captive buyer of long-dated debt, which changed the nature of the market. Shrinking the balance sheet has proven difficult because the market has become so dependent on the Fed buying and providing liquidity.

The new policy has not come without costs. It means that the Fed now takes on duration risk. The reserves are short-term liabilities, since banks may demand them at any time. But the Fed uses them to buy long-term assets. If rates go up, then the Fed’s assets will fall in value, but it will still have the same short-term liabilities. The rising-rate environment has cost taxpayers billions of dollars. Even more worrying, the large balance sheet poses a big threat to independence.

Any country that runs a large debt struggles to maintain an independent central bank, but that task becomes even harder when paired with a large balance sheet. A high debt burden tempts policymakers to inflate away debt or to keep interest rates low in order to reduce debt-service payments. Both are forms of financial repression, and both are enabled by a large balance sheet.

The pre-2008 Fed policy had limited impact on longer-term bonds, and thus the scope for financial repression, while still possible, was somewhat restrained. But a large balance sheet makes it possible to suppress interest rates of all maturities or buy other forms of debt, all of which can keep debt service costs lower. This is one reason why Japan’s economy struggled to grow the last few years.

The sheer size of the balance sheet also becomes a source of temptation to use the money. During the pandemic, the CARES Act directed the Fed to use its assets to lend to middle-market firms. The Federal Deposit Insurance Corporation went to the Fed for its bailout of Silicon Valley Bank. As long as the Fed maintains such a large balance sheet, the temptation to use it for political programs will only grow as the government becomes more debt constrained.

Warsh was one of the few candidates for Fed governor who expressed a clear desire to shrink the balance sheet. It will not be easy, but if he does it, that may do more for Fed independence than anything else in the last 20 years.

Powell leaves a mixed legacy: he fought for Fed independence, but his expansion of the balance sheet undermined it. If Warsh succeeds in reducing the central bank’s balance sheet, he will have the better claim to preserving Fed independence.