“I am suspicious of the idea of a new paradigm, to use that word, an entirely new structure of the economy.” - Paul A. Volcker
I have been and am a Fed Watcher. Fed watchers are a subclass of financial writers and analysts that specialize in observing and disseminating information about the world’s most important central bank. I wrote the weekly Fed Watch column for Fundstrat Global Advisors for both institutional and retail investors for over two years and closely observed the entire last cycle that recently culminated in a big 50 bps rate cut right before the election.
It was an extraordinary cycle where Jay Powell may have been fashionably late, may have stumbled over terms like transitory, but ultimately, he delivered a fabled economic soft landing—the great white buffalo. Kudos to him.
But now he has an even tougher battle ahead of him, and right then he should instead be taking a victory lap and accepting the praise of the erudite class of Fed watchers and Washington policy elite. Instead, he has now staked out a position as one of the main sources of opposition to Donald Trump’s incoming administration whether he likes it or not. The Fed is not supposed to be political; it’s given broad powers of independence in both funding and policy decisions from the Federal Reserve Act.
Currently, under the letter of the law, the Federal Reserve Chairman cannot be fired or demoted; however, that doesn’t mean the President-Elect won’t be able to use the bully pulpit, and perhaps other tools, to ensnare the current Chairman. In the last Fed meeting, which was otherwise inconsequential, Powell stated that he would not leave if the President asked him to step down, and that the President did not have the legal power to fire him. One thing that could stymie Powell’s ability to signal to markets is if the President-Elect were to appoint a shadow Chairman that communicated a different message to markets than the current Chairman. He could also try to use the red sweep in Congress to change the Federal Reserve Act, either to water down or eliminate its independence.
Generally, it should be assumed that markets may fight back against the ideas of Trump to limit Federal Reserve independence. The independence of the Federal Reserve is specifically designed to create separation of the Fed’s economic mission from short-term political incentives. If this is retracted or undermined by President Trump, the credibility of US markets would likely suffer a major blow. In my estimation, this is one of the main sleeper risks that markets will have to digest during a Trump administration.
There have been a number of proposals to crimp or remove Federal Reserve independence over the years. Other areas of the Fed, like the idea to have regional economy representatives as regional bank presidents, have faded with time as the institution has become more dominated by Wall Street types and academic economists. But the proposals have largely been ideologically centered. Trump appears to think he should have a say in interest rate setting because of his past success in business.
"I feel that strongly. I think that in my case, I made a lot of money, I was very successful, and I think I have a better instinct than, in many cases, people that would be on the Federal Reserve or the chairman." -President-Elect Donald Trump
So, Trump’s policies are not very well formed at this point. But to give a map of where his administration may go in their effort to give the President more power of setting rates, we should give you the existing universe of proposals to curb Fed independence and the rationale behind them:
1. Increased Treasury Oversight of Monetary Policy
Proposal: Some proponents suggest giving the Treasury Department more authority to oversee the Federal Reserve's actions, particularly when the Fed engages in emergency lending or asset purchases, such as during a financial crisis.
Rationale: This proposal argues that since the Fed's crisis interventions affect government debt and fiscal policy, Treasury oversight would ensure coordination between fiscal and monetary policies. This approach also aims to improve transparency and accountability for decisions that have fiscal implications.
2. Bringing the Fed Under Executive or Congressional Control
Proposal: This approach involves subjecting the Fed’s policy decisions to direct control by the executive branch (such as the Treasury or the President) or increasing Congress's authority to set monetary policy goals.
Rationale: Advocates of this model believe that monetary policy, as a key determinant of economic growth, should align more closely with the elected government's policy goals. They argue that Congress and the executive branch, being democratically elected, can better reflect the public’s will on economic issues than an independent central bank.
3. Eliminating the Federal Reserve’s Independence
Proposal: In a more radical shift, some suggest fully eliminating the Federal Reserve’s independence and integrating it into the Treasury. This proposal would essentially make the Fed a department of the Treasury, with the Treasury Secretary overseeing all monetary policy.
Rationale: Proponents argue that, given the Fed’s growing role in asset markets and fiscal-like actions (such as large-scale bond buying and lending programs), it should no longer be a fully independent entity. They contend that this alignment with the Treasury would ensure better policy coherence, particularly in times of crisis when fiscal and monetary policies need to work closely together.
4. Limited Role of Fed in Fiscal Policy; Treasury to Assume Responsibility
Proposal: Under this model, the Fed would maintain some degree of independence but would relinquish control over fiscal-style interventions (e.g., quantitative easing, large asset purchase programs) to the Treasury.
Rationale: This proposal seeks to limit the Fed’s reach into fiscal territory, as these actions are traditionally the domain of government spending and debt issuance, areas directly controlled by the Treasury. By confining the Fed’s role to traditional monetary policy (interest rate setting, managing reserves), the Treasury could take responsibility for any interventions with direct fiscal implications.
5. People’s QE or Direct Government Financing
Proposal: This concept involves "People’s Quantitative Easing" (People’s QE), where the Treasury, rather than the Fed, would issue new money directly for government projects or social programs, bypassing the banking system.
Rationale: Supporters believe that instead of using monetary policy to influence markets and indirectly stimulate the economy, People’s QE would allow the government to directly fund infrastructure, education, healthcare, or other projects, ensuring that newly created money has an immediate, direct impact on the public.
One of the main problems with compromising Fed independence, according to both left-wing and right-wing economists, is that the President’s economic incentives are short-term, whereas being the world’s reserve currency requires long-term planning and thinking. The kind that is afforded by the Federal Reserve’s independence.
Still, even if the establishment is firmly in favor of preserving the status quo with respect to the US central bank, as CNBC’s Steve Liesman said jokingly, those who offer firm political support for the Federal Reserve could probably fit on the Staten Island Ferry. So, populism very well may make one of America’s most hallowed financial institutions one of its most visible victims.
One thing is for sure, the outcome of the faceoff between Donald Trump and Jay Powell will have far reaching for the US dollar, stock markets, and the character and volume of global trade. Depending on what happens, markets could throw their largest Fed tantrum of all time.
The Triffin Paradox would likely be exacerbated and could lead to financial instability. The Triffin Paradox is defined by the tug and pull between the following incentives:
Global Liquidity Needs: A reserve currency must supply the global economy with enough liquidity to facilitate international trade and investment. This usually requires persistent current account deficits by the issuing country to ensure that foreign entities accumulate reserves of its currency.
Domestic Stability: Running consistent current account deficits can lead to an unsustainable accumulation of external debt, undermine confidence in the reserve currency, and potentially destabilize the domestic economy.
The Federal Reserve gets a lot of heat thrown on it from a lot of places, but one thing is clear. Financial markets view the Federal Reserve as a source of independent authority regarding economic issues, and it values the function that the central bank plays. The consequences of reducing or eliminating Federal Reserve independence could be severe for markets, and it is a risk we will continue monitoring here at Punk Rock Traders.
