We are on the verge of testing a prediction made by Professor Karen Johnson 50 years ago. Prof. Johnson was teaching monetary theory at Stanford in the spring quarter 1975. I was in the class. She began by noting that the Federal Reserve is set up as an independent agency. But it’s also part of the executive branch. That seems to be a contradiction. She went on to speculate about the outcome of a potential Supreme Court case regarding the Fed’s independence. The Federal Reserve is about to enter perilous waters.
And here we are today. Several cases about this issue are currently petitioned to SCOTUS. (The court usually only accepts a small fraction of petitions. But my uninformed guess is that this one has a pretty good chance.) The best example is petition 24-969:
Community Financial Services Association of America, Limited v. Consumer Financial Protection Bureau.
Whether, in order to obtain judicial relief, a party challenging governmental action taken by an individual who remained in office against the president’s wishes due to an unconstitutional removal restriction must show that a hypothetical replacement officer would have taken a different action.
In other words, does the president have the power to fire employees that are part of the executive branch? Prof. Johnson thought the answer was, “Yes.” So far, the Supreme Court has pretty much agreed with her.
So here we are. President Trump thinks the Fed should cut interest rates.
Mr. Powell has pointed out (correctly) that Mr. Trump’s tariffs would lead to a one-time increase in the average price level. Regular readers (both of you) will immediately recognize this as a negative supply shock, described here. Under my proposed rule of “First, Do No Harm,” a neutral policy of not changing aggregate demand is appropriate.
Cutting interest rates is an increase in aggregate demand. Essentially, Mr. Trump is asking the Fed to turn his one-time price level rise into actual inflation, an ongoing increase in the average price level. That policy also would increase economic growth and probably lower unemployment. The Fed believes (again, correctly) that the economy is currently at full employment. Cutting interest rates will overheat the economy, leading to inflation.
Sadly, Mr. Trump seems to be listening to Peter Navarro:
No good will come of this. I fear for the future of central bank independence. To see why that matters, refer to the research of Larry Summers and Alberto Alesina. Here’s their abstract:
Dynamic inconsistency theories of inflation make it plausible that more independent central banks will reduce the rate of inflation. Central bank independence might improve real economic performance for several reasons. An independent central bank may behave more predictably, promoting economic stability. To the extent that high inflation has adverse effects on economic performance, one would expect central bank independence to improve economic performance. Results from an empirical study suggest that the monetary discipline associated with central bank independence reduces the level and variability of inflation but does not have either large benefits or costs in terms of real macroeconomic performance. The degree of central bank independence is only one of several institutional factors, exchange rate arrangements, and exogenous shocks that influence economic performance in different countries.
(Alesina, Alberto and L.H. Summers. “Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence.” Journal of Money, Credit, and Banking, Vol. 25, No. 2 (May 1993))
But let’s cut to the chase. What’s the relationship between central bank independence and inflation? The authors answer that in their Figure 1a:
(click for larger image)
Aha! More independent central banks lead to lower inflation rates. Independence matters. A lot.
This is, of course, the exact subject of the current dispute between Mr. Powell and Mr. Trump. Mr. Powell knows that tariffs and other trade restrictions will lead to an increase in the average price level. Lowering the interest rate would require increasing the growth rate of M2. Which would validate the higher price level and turn it into full-blown inflation.
Mr. Trump realizes he does not know economics. Unfortunately, he is listening to perhaps the only economist in the world that agrees with his nutty views. Keep a close eye on this potential legal case. It may be headed to SCOTUS. If it does, I pray for the future of our republic.
