What Happens After The Fed Ceases To Be Independent

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📝 usncan Note: What Happens After The Fed Ceases To Be Independent

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The odds are high that the Fed will come under the control of President Trump and cease to be an independent decision making body. The odds are also are high that the country will adopt an expansionist monetary policy in order to lower interest rates. The long term risk is high that the U.S. economy will enter a period of sustained stagflation and instability. The risk is high that instability in the U.S. financial system will ripple through the global financial system, generating a financial crisis. The risk is high that the dollar will decline in value. The risk is high that the loss of Fed independence will accelerate a change in the world order that is currently underway, with a shift in power from the U.S. to China, Russia, and India.

Two milestone events took place during the first week of September, one relating to the loss of Fed independence and the other to the changing world order. The connection between the two events is that the loss of Fed independence will accelerate the change in world order. Neither is to the advantage of the U.S.

The first event featured a Senate confirmation hearing to approve the appointment to the Fed board of Stephen Miran, the head of the president’s Council of Economic Advisers. Miran stated that if appointed, he will not resign from his CEA position. Instead, he will only take a “>temporary leave, raising the question of presidential participation in Fed decision making.

The second event featured China hosting a summit in Beijing that was attended by the leaders of Russia, China, India, and North Korea. The purpose of this summit was to form an alliance to counter American power.

What Exactly Is A U.S. Dollar?

The Fed deals in dollars, and so it is important to understand what dollars really are. There is a right way and a wrong way to think about the key properties of dollars and the money supply. The wrong way to think about dollars is as dollar bills; and the wrong way to think about increasing the money supply is as a printing press, printing more dollar bills.

The right way to think about dollars is as entries in an accounting ledger. When the U.S. Treasury issues a Treasury bill, it can sell that bill to the public or it can sell the bill to the Fed. The Fed is the Treasury’s bank, and so naturally the Treasury has a checking account with its bank. If the Treasury sells the bill to the Fed, the Fed credits the Treasury’s account, thereby creating a Fed-IOU: The Fed’s IOU can be read as “I owe you one U.S. Treasury bill.” The Treasury needs the IOU because when the bill matures, the Treasury will redeem it and it will go off the Fed’s books.

The face value of a Treasury bill is typically “a thousand;” and 1/1,000 of the associated Fed-IOU constitutes a dollar. This is the way to think about the meaning of a dollar. In other words, U.S. dollars are effectively just portions of Fed-IOUs for Treasury bills.

When the U.S. military pays a soldier $100, the Fed transfers 10% of a Fed IOU from the Treasury’s account to the financial institution where the soldier banks. Then the soldier’s bank deposits that $100 Fed-IOU into the soldier’s account. If the soldier buys $100 of groceries from a grocer and pays by check, the grocer receives 10% of a Fed IOU, which goes through the grocer’s bank.

When the grocer’s bank accepts the $100, and credits the grocer’s bank account, the grocer receives a different IOU, the bank’s IOU. The bank-IOU is shorthand for “I, the bank, owe you, the grocer, one-tenth of a Fed-IOU for a Treasury bill.” The bank’s liability is not an obligation to return a portion of a Treasury bill. It is an obligation to return a portion of a Fed-IOU for a Treasury bill.

Federal Funds And Open Market Operations

Banks that are members of the Federal Reserve system hold reserve accounts with the Fed. As such, they are required to maintain a minimum ratio of reserves-to-deposits. Reserve requirements can help assure depositors that the risk of a run on their bank is low. Banks borrow funds from each other, overnight, to manage their balance sheets and reserve requirements. These funds are known as “federal funds,” the associated market is the “federal funds market,” and the associated interest rate is the “federal funds rate.”

The Fed operates in federal funds market, and controls the federal funds rate through its purchases and sales. This is the major activity of Fed’s Federal Open Market Committee.

The federal funds rate is currently about 4.3%. If the Fed would wish to drive down the federal funds rate, it would buy short-term securities, such as Treasury bills, from banks, in exchange for the dollars these banks would need to satisfy reserve requirements. Such purchases drive up the price of these funds, which in turn decrease the associated yield.

Risks That Will Be Amplified By A Loss In Fed Independence

Run risk: Consider the preceding example of the soldier purchasing $100 from the grocer. When the grocer’s bank receives the $100 and the grocer holds the $100 in its account, the grocer accepts a series of risks. One such risk is that the bank will lend those dollars to somebody else, and as a result, the bank will not have enough dollars on hand if the grocer decides to withdraw them. If enough depositors worry that this is the case, a run on the bank ensues, and the bank fails. In 2023, this is what happened to Silicon Valley Bank.

Inflation risk: The Fed operates directly on the federal funds rate, and through its open market operations can bring the rate down. A lower interest rate will reduce the future interest payments the Treasury will make on its debt, invigorate the mortgage rate, and generally stimulate the U.S. economy.

Member banks of the Federal Reserve system bank with the central bank, meaning the Fed. When the Fed buys short-term securities from a bank, it credits the dollar account of this bank, allowing the bank to increase the amount it lends out. Lending money is a major profit activity of a bank. The result is that the money supply increases.

If the money supply grows faster than economic production, and people spend that money rather than hold it, the end result will be inflation: too much money chasing too few goods. Then the real value of dollars, meaning their purchasing power, declines.

Systemic risk: The combination of low interest rates and an expanding economy encourages speculation and imprudent risk taking. This typically leads to interconnected debt arrangements such that a default by a key market participant induces a cascade of defaults by other participants whose ability to cover their own debt obligations relied on parties who have defaulted. The interconnections mean that the risks are systemic, and render the system much more vulnerable to a financial crisis.

Default risk: There is a risk that the Treasury will default on its obligations, so that the dollars, meaning the Fed-IOUs, lose value or even become worthless. The probability of such a default is not zero. In May 2023, a political stalemate led Congress to flirt with the possibility of default by not raising the federal debt limit. Two years later, Moody’s downgraded U.S. federal debt from Aaa to Aa1, attributing the downgrade to a combination of a large government deficit, high debt, and high costs of servicing that debt in a high interest rate environment.

Currency Risk: The U.S. dollar is the main reserve currency for the international financial system. This means that the central banks of foreign countries hold a lot of U.S. Treasurys. The prices of many commodities, such as oil, are quoted in dollars. U.S. financial firms are at the heart of global finance. This has enabled sanctions to be a very effective tool of foreign policy.

A major reason why the U.S. dollar is the main currency at the heart of the international financial system is that the U.S. is the most active player in world trade. However, that is not the only reason. What is also important to foreign holders of dollar-denominated assets is the relative safety of these assets, owing to the strong performance of the U.S. economy, with low inflation and a stable financial sector.

When The Fed Becomes An Instrument Of The President’s Political Agenda

President Trump has been pressuring the Fed to use open market operations to bring interest rates down. The Fed has been resisting. However, the last two employment reports have indicated that the U.S. labor market is slowing; and as a result, the Fed has been signaling that it will soon reduce the federal funds rate.

Nevertheless, as one more step in moving the U.S. to autocracy, the president seems intent on taking control of the Fed. He has been vocal in saying that the Fed has kept interest rates too high for too long. He has been pressuring Fed chair Jerome Powell needs to resign. He is attempting to fire Fed board member Lisa Cook, claiming that she has committed mortgage fraud. In turn, she has sued, arguing that he lacks the legal authority to fire her. This past week, he nominated Stephen Miran, the head of his Council of Economic Advisers, to fill a Fed board vacancy. However, Miran would not resign from the executive branch, but only take a temporary leave, thereby creating the possibility of a direct formal channel between the president and Fed Board of Governors.

A Fed controlled by the president will amplify all of the risks described above to dangerous levels.

The Fed has two broad functions. The first function is to use monetary policy to stabilize inflation at a moderate level, while promoting low unemployment. The second function is to regulate systemic risk in financial markets with the goal of promoting stability. Ben Bernanke, who was Fed chair during the global financial crisis stated that the most important lesson he learned from the crisis was that the regulatory function is as important as monetary policy.

Expansionary monetary policy and weak regulation can serve to stimulate the economy in the short term, but sow the seeds of instability in the long term. Because presidents have short-term horizons, based on election cycles, they are prone to focus on the short term. This means that the country, and perhaps the world, is prone to pay a high price in the long term – if the president gets his way.

Having an independent Fed is like having an adult in a room of children, to make rational decisions instead of emotional decisions. Losing Fed independence is like giving free rein to emotional, irrational decision making.

Long term, expansionary monetary policy leads to inflation. Whereas expansionary monetary policy puts downward pressure in the short term, the subsequent surge in inflation causes interest rates to rise. That is what happened to U.S. rates in the 1970s.

The combination of high inflation and high interest rates, relative to the rest of the world, makes holding U.S. dollar denominated assets less attractive, a situation that will cause the dollar to decline in value.

In the past, when the U.S. was on the gold standard, Fed-IOUs were for ounces of gold rather than Treasury bills. The price of gold going up is a signal that U.S. Treasurys are becoming less attractive. During 2024, the price of gold rose by 34%. Since President Trump took office, the price of gold has risen by another 30%.

President Trump’s tariff policies are attempting to reshape the global trade patterns. Through extraordinary tariffs, he appears intent on the U.S. adopting mercantilism as its economic system. Mercantilism entails running a trade surplus, high tariffs, and an industrial policy that favors particular sectors.

The rest of the world is responding to President Trump’s tariffs, and in the long run, trade with the U.S. will decline. This will make the U.S. dollar less important in global trade activity. As hedge fund legend Ray Dalio has consistently pointed out, the decline in the use of the U.S. dollar as a reserve currency is part of a changing world order. President Trump’s tariffs increase the risk, to the U.S., that China will supplant the U.S. as the world’s financial superpower.

There is a fundamental macroeconomic relationship that is not drawing enough attention in discussions of economic policy. The relationship states that a country’s government budget deficit is funded from two sources:

1. domestic net savings, meaning savings minus business investment; and

2. borrowing from abroad, which is the negative of the trade surplus.

The U.S. federal deficit is currently about 7% of gross domestic product. Dalio has warned that within the next three years, the deficit will need to decline to 3% of GDP. If not, interest on the national debt will become the dominant expenditure of the federal budget, and a very negative drag on U.S. economic performance.

President Trump’s 2025 budget, passed into law under the name One Big Beautiful Bill, increases the federal deficit. If the deficit remains high, and the president successfully turns the trade deficit into a trade surplus, then the fundamental macroeconomic relationship requires that net savings surge. For that to happen, savings will have to soar, or investment will have to plummet, or both. Either way, the risk is high that the impact on the U.S. economy will be very negative – stagflation is we are lucky, a protracted downturn if we are unlucky.