Fed Independence in the Crosshairs

The selection of Kevin Warsh as the next Fed Chair comes at a time when Fed independence is being challenged like never before. Research and experience are clear on the danger of higher and more volatile inflation once central bank independence is lost.

You have probably seen the headlines that Fed independence is being threatened, but you might not know the history of Fed independence, or why economists and central bankers spend so much time and energy defending it. In this week’s Feature, we dive deeper into the history of Fed independence, discuss how that independence is under threat today, and why that could lead to trouble down the road.

First a little background. The Federal Reserve was created by an act of Congress in 1913, but it wasn’t until 1977 that another act of Congress added the dual mandate to promote maximum employment and stable prices. This update on the Fed’s mandate occurred during the stagflationary era of the late 1970s and follows the serious erosion of central bank independence during the Nixon Era.

It is widely accepted in the academic literature and central banking theory and practice around the world today that these mandates can best be achieved when the central bank, in this case the Federal Reserve, is independent. Independence in this context means the Fed can set interest rates largely without interference from Congress or the White House even if politicians are unhappy with Fed policy. Central banks in nearly all major capitalist democracies are similarly insulated from the political fray. The politicians set the mandates, but the central banks’ have the freedom to set interest rates and reserves to achieve those mandates. In practice, however, this independence is more on a sliding scale and can vary by country and over time depending on political pressure, personalities, and economic conditions.

Fed Independence Has Been Challenged Before

Fed independence was seriously eroded during the Nixon Era (1969-1974). Then-President Nixon was deeply concerned with reelection in 1972 and believed tight monetary policy cost Republicans elections. At the time, inflation was already elevated due to the Vietnam War, Great Society programs, and the loose fiscal policies of the 1960s. Nixon appointed Arthur Burns, a close personal adviser who was politically sympathetic to the president’s priorities, as Fed Chair in 1970. Nixon explicitly demanded easy money to boost growth before the 1972 election. Oval Office tapes, released subsequently, revealed Nixon threatening Burns’ reputation, questioning his loyalty, and repeatedly pushing for lower rates. Sound familiar?

In response, Burns largely accommodated the White House demands. Monetary policy from 1971 to 1972, in retrospect, is widely seen as overly accommodative. Inflation pressures were dismissed as “cost-push” (driven by wages, oil, and unions) and the case was made that inflation could not be controlled by monetary policy alone. Instead, Nixon tried wage and price controls to tamp down inflation, including a 90-day wage and price freeze that was implemented in August 1971. Of course, we all know how this story ended. Inflation surged after wage and price controls were lifted, an OPEC oil embargo in 1973 worsened the price pressures, and inflation expectations became even more unhinged (Chart 1). Presidents’ Ford and Carter also tried to pressure the Fed, though less aggressively, and the Fed (still under Burns and then G. William Miller) remained reluctant to pursue severe monetary tightening for fear of worsening unemployment or a political backlash.

It took Paul Volcker, appointed in 1979, to restore the Fed’s independence. Volcker shrugged off political considerations, raising interest rates dramatically to crush inflation—high unemployment rates and recession be damned. Indeed, prior to the pandemic, the 1981-1982 Volcker recession created the highest post-war unemployment rate of 10.7% (Chart 2). Volcker took his cue from Milton Friedman, targeting the money supply directly and adhering to the idea that inflation is “always and everywhere a monetary phenomenon”. This reassertion of independence during the Volcker Era is credited with restoring the Fed’s inflation-fighting credibility and bringing bond market yields and inflation expectations back down to earth, where they have largely stayed ever since (Chart 3).

Why Economists Care So Much About Fed Independence—and Why You Should, Too

The rationale for central bank independence is very straightforward. Politicians, by their need for re-election, have a strong incentive to favor lower interest rates, all else equal, to give the economy a short-run boost, even if it comes at the expense of more inflation, higher long-term interest rates, and weaker growth later. An independent Fed, insulated as much as possible from the political process, is more likely to make politically unpopular decisions when needed to keep inflation and the labor market as close to Congress’s mandates as possible. As Fed Chair William McChesney Martin Jr. said in a 1955 speech, the Fed’s job is to “take away the punch bowl just as the party gets going”.

A large body of empirical and theoretical research shows that independent central banks deliver lower and more stable inflation without harming real economic performance. Seminal empirical work—including Bade and Parkin (1982) [1], Alesina (1988 [2], 1989 [3]), and Grilli, Masciandaro, and Tabellini (1991) [4]—consistently finds that greater central bank independence is associated with lower inflation. Alesina and Summers (1993) [5] extend this evidence, concluding that independence improves price stability while having no measurable effect on growth, unemployment, or real interest rates. These findings align with the theoretical foundations laid by Kydland and Prescott (1977) [6], Barro and Gordon (1983) [7], and Rogoff (1985) [8], which highlight how insulating monetary policy from political pressures reduces inflationary bias. Given the well-documented damage that high inflation inflicts on consumer confidence and household welfare, the case for independent central banks remains compelling.

One of the best modern real-world examples of the importance of central bank independence for inflation control comes from Türkiye (Chart 4). Prior to the early 2000s, Türkiye’s central bank was not considered independent from the Executive branch and the country suffered from rampant inflation. But after the 2001 financial crisis, Türkiye’s central bank law was amended to grant formal independence. The central bank soon set up an implicit inflation targeting policy regime (2002-2005), and then a fully-fledged one in 2006. Inflation swiftly fell into the single digits, and Türkiye was seen as a model emerging market reformer. Post-2010, the country’s commitment to its inflation targets started to drift toward prioritizing growth and credit expansion and targets were routinely missed.

Then, when President Recep Erdogan came to power in 2014, we saw the de facto abandonment of inflation targeting as the President began to argue that high interest rates cause inflation, not the other way around. Erdogan swiftly gained direct authority over senior central bank appointments. Since 2019, Erdogan dismissed multiple central bank governors for raising interest rates to fight inflation. Tenure became conditional on political compliance and markets swiftly learned that monetary tightening would not be tolerated. Türkiye’s central bank has cut rates even as inflation surged into double digits, pursuing growth and exports over price stability. This is textbook political dominance of monetary policy, making the country a poster child for what could go wrong when a central bank loses its independence from politicians. Today, inflation has again become entrenched and volatile in Türkiye. The Turkish lira has experienced repeated sharp depreciations requiring a heavy draw-down of FX reserves to stabilize the currency. Savers have been punished with negative real returns, credit allocation has become politicized, and corporate and household balance sheets have been distorted by inflation and FX risk. Inflation expectations became unanchored and central bank credibility and independence was severely damaged. This has done tremendous damage to Türkiye’s banking and financial system that was thriving in the early 2000s when inflation was brought under control. Once central bank credibility is lost it cannot be rebuilt quickly.

Fed Independence Under Threat Again Today

The Trump Administration’s attempts to remove Jay Powell, Lisa Cook, and the near-daily public pressure to lower interest rates is a clear attempt by the Executive branch to once again to put its thumb on the scale of monetary policy and to run the economy “hot” going into the mid-term elections. Repeatedly saying things like the Fed is “too late” on cutting interest rates and that rates should be “3.0 percentage points lower today” intensifies the political pressure on the FOMC to cut rates aggressively. Of course, keeping interest rates artificially low and monetary policy loose would likely come at the expense of higher inflation and inflation expectations, a weaker U.S. dollar, and could do long-term damage to the Fed’s independence and inflation fighting credibility. Higher inflation and potentially higher long-term interest rates are not a trivial matter when a country is carrying US$39 trillion in debt.

The President can influence Fed policy most directly through his nomination of members of the Federal Reserve Board subject to confirmation by the Senate. Jay Powell’s term as Chair expires in May 2026, but his term as Governor doesn’t expire until January 2028. So, Powell could remain on the Board and continue to vote on monetary policy even if he isn’t Chair. The Federal Reserve Act says Fed Governors can only be removed by the President before their term expires “for cause”. Attempts to remove Lisa Cook from the Federal Reserve Board for alleged mortgage fraud and to criminally investigate and possibly indict Jay Powell for allegedly misleading Congress on his management of the Eccles Office Building renovation could provide the justification to remove both Powell and Cook “for cause” and allow the President to place loyalists in both Board seats, should Powell decide to remain beyond May (Table 1).

While history doesn’t repeat, it often rhymes. Global history is replete with examples of central banks that lost their independence and governments that lost their financial way. The Fed’s own experience in the 1970s provides another cautionary tale closer to home. Monetary policy theory is clear on the dangers of higher inflation from lost independence and the many empirical academic studies concur. In the Administration’s hurry to assert more influence over Fed interest rate policy, the danger of higher inflation, higher long-term bond yields, and worsening dollar depreciation is very real. For now, the U.S. still has the most liquid financial markets and efficient banking and credit allocation system in the world. Let’s not take that for granted. Even a small step away from Fed independence needlessly puts that preeminent status at risk.

[1] Bade, R., and M. Parkin. 1982. “Central Bank Laws and Monetary Policy.” Unpublished manuscript. [^]

[2] Alesina, Alberto. “Macroeconomics and Politics.” NBER Macroeconomics Annual 3 (1988): 13–52. [^]

[3] Alesina, Alberto, James Mirrlees, and Manfred J. M. Neumann. “Politics and Business Cycles in Industrial Democracies.” Economic Policy 4, no. 8 (1989): 57–98. [^]

[4] Grilli, Vittorio, Donato Masciandaro, Guido Tabellini, Edmond Malinvaud, and Marco Pagano. “Political and Monetary Institutions and Public Financial Policies in the Industrial Countries.” Economic Policy 6, no. 13 (1991): 342–92. [^]

[5] Alesina, Alberto, and Lawrence H. Summers. “Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence.” Journal of Money, Credit and Banking 25, no. 2 (1993): 151–62. [^]

[6] Kydland, Finn E., and Edward C. Prescott. “Rules Rather than Discretion: The Inconsistency of Optimal Plans.” Journal of Political Economy 85, no. 3 (1977): 473–91. [^]

[7] Barro, Robert J. & Gordon, David B., 1983. “Rules, discretion and reputation in a model of monetary policy,” Journal of Monetary Economics, Elsevier, vol. 12(1), pages 101-121. [^]

[8] Rogoff, Kenneth. “The Optimal Degree of Commitment to an Intermediate Monetary Target.” The Quarterly Journal of Economics 100, no. 4 (1985): 1169–89. [^]

New Year… New Prolonged Pause?

As expected, the Fed kept policy rates unchanged on January 28 with the target range for the fed funds rate at 3.50%-to-3.75%. This followed quarter-point cuts in each of the past three confabs. And we are starting to judge that this at-least three-month pause (the next meeting is March 18) will last longer.

Recall that 2025 also began with a hold after three consecutive cuts (worth 100 bps). The eventual nine-month pause reflected heightened economic policy uncertainty and the stagflation risk posed by tariffs. And there was recognition that policy rates were still on the restrictive side, imparting an easing bias. Rate reductions resumed as the economic policy picture clarified and, importantly, as the Fed began to judge that the “downside risks to employment have risen” after being comparable with the upside risks to inflation. This net risk tilt was similarly mentioned alongside each of the past three rate cuts.

This month, with the Fed on hold, the net risk skew was removed. The policy statement was also more upbeat on the economy. For example, it said “economic activity has been expanding at a solid pace” versus “moderate” before. And “the unemployment rate has shown some signs of stabilization” versus having “edged up” before. Meanwhile, “inflation remains somewhat elevated.” Less downside employment risk plus still somewhat sticky inflation reduced the Fed’s easing appetite, particularly, as Chair Powell noted in the press conference, with policy rates in the “range of plausible estimates of neutral”. The FOMC’s latest median projection of the longer-run or neutral fed funds rate is 3.00% implying an endgame of either 2.75%-to-3.00% or 3.00%-to-3.25% (we’re leaning to the lower range). It could take a while to get there, however (if at all).

Powell also said that “after this meeting, after the three recent rate cuts, we’re well-positioned to address the risks that we face on both sides of our dual mandate.” This does not sound like a rate cut is being teed up for the next meeting. Indeed, Powell said they “haven’t made any decisions about future meetings” and will “be looking to our goal variables and letting the data light the way for us.” We are waiting for the same data beacons.

Bottom Line: We now look for the next Fed rate cut in June (three months later than before). Amid economic momentum spilling over from the second half of last year (thank you, wealth effect and AI/automation-related capex), the rebound from Q4’s government shutdown, larger tax refunds, and new tax cuts kicking in, the data will likely be lighting the way to a pause for at least the next several months.

Washington’s Wild Week: Warsh and Warding Off a Shutdown

The final week of January is ending just as it began in Washington: like a lion. Two events, in particular, came to the fore on Friday: The President nominated Kevin Warsh to become the new Fed Chair in May, and Congress scrambled to avert another federal government shutdown. Warsh’s nomination still needs to be approved by the Senate Banking Committee. Despite a few lawmakers claiming they won’t approve any nominations until the White House’s legal proceedings against the Fed, Chair Powell, and Governor Cook are resolved, there’s a reasonable chance Warsh will get the nod given his experience as a Fed Governor (2006-2011) and general Republican support.

Warsh was chosen despite his past hawkish credentials, earned during the financial crisis when he favored tighter policies than were put in place. In 2008, at the depths of the crisis, he said that extra rate cuts could ignite inflation. He also pushed back against quantitative easing in 2011, when the FOMC opted to buy Treasury bonds to further reduce long-term rates. As the new Chair, Warsh will likely promote shrinking the Fed’s balance sheet by either selling Treasuries or not reinvesting maturing proceeds. That could put mild upward pressure on long-term rates, and, in fact, 10-year Treasury yields inched up on the announcement.

Shorter-term rates, however, fell slightly (steepening the yield curve) as fed funds futures priced in somewhat higher odds of at least two rate cuts this year. Indeed, any moves toward shrinking the balance sheet could warrant additional rate cuts. More recently, Warsh has been a consistent proponent of lower rates, for two reasons. First, he believes artificial intelligence will be a “significant disinflationary force” by boosting productivity. Second, he thinks that excessive government spending and money printing are the root causes of inflation. Unless inflation sparks, he is likely to try to run the economy hot. This more reactive than preemptive approach could fan inflation, but it may also prove prescient if productivity growth strengthens and contains price pressures.

Of course, the new Chair would still need to coax six other members of the 12-member FOMC to vote likewise, but that may not be a major issue given his prior experience at the Fed and the view that current policy rates are still near the upper end of a neutral range. This assumes inflation makes some further progress toward the target and job growth remains soft for much of the year.

The upshot is that Warsh is almost certain to push for lower policy rates, at least in the near term. His nomination supports our outlook for three more rate cuts this year, taking policy to a mildly stimulative setting. Pushing for even more rate cuts, as the President recommends, could run into resistance if the economy continues to outperform and inflation remains sticky. That’s when the issue of Fed independence will be put to the test. But Warsh’s record suggests he may be up to the test, and that upside inflation surprises would not be tolerated.

Turning to the prospect of a second federal government shutdown in less than three months, the good news is that the odds of a deal appear high; and even if there is a partial closure, the economic sting will be much less than in the fall.

Half of the twelve annual appropriations bills have already been signed into law by the President. They cover funding for Justice, Commerce (including the Census Bureau), and several other departments. This implies less disruption than the closure late last year. Moreover, the House has already approved the remaining six bills that would fully fund the government through September. However, sixty votes are required to advance these bills in the Senate, meaning that Republicans (who have a 53-47 seat majority) will need some Democrat support. The latest news suggests the White House and Senate Democrats have agreed on a deal for five of the bills, all except immigration. If passed in the Senate, the House would need to approve the changes, which might be delayed a few days.

Absent passage of the six funding bills, a continuing resolution would need to be approved to temporarily cover funding for some departments, including the Bureau of Labor Statistics. If this fails, we could see delays in the employment and CPI reports. But continued funding for the Commerce Department will keep scheduled releases for real GDP, retail sales, personal spending, and the all-important PCE price data on track. Even without passage of the remaining bills or a continuing resolution, much of the government would stay open. While hundreds of thousands of federal employees could be furloughed or required to work without pay, a shutdown of equal duration as the last one would have a much smaller impact on the economy, likely less than half a percentage point hit to Q1 annualized growth. That could easily be offset by the continued AI boom now propelling business investment.