Anyone who has ever piloted a ship, taken the wheel of a powerboat, or sat on the tiller of a small sailing vessel can tell you about the problem of over steering and lagged reaction. Keeping the ship on course requires small corrections and big patience. Oversteer and your path starts to zig zag, leading you to over correct and so on.
The management of monetary policy by the Federal Reserve follows a similar concept. There are significant lags in the economy after a change in the fed funds rate, whether it be a hike or a cut. And it is not so different from driving a boat. Sometimes you may need to make a hard shift to the right or left to avoid a hazard in the water. But most of the time, tiny corrections will lead to a smooth arrival at the destination. And here is the thing, the larger the ship, the more critical this becomes because the lag times increase with vessel size.
The US economy is the biggest ship out there, and it requires a steady hand at the helm. In the last few months, the fed has come under political fire. President Trump hinted at firing chair Powell until there was pushback from the markets. Later, a series of politicians, led by the president, began to make public remarks about the need to cut interest rates immediately and to criticize the agency for being “too late” to act. There seems to be a misunderstanding about the way policy is conducted. The Fed chair doesn’t make a determination on his/her own. The federal open markets committee votes on policy and takes into account a mountain of economic data from across the country.
Now more recently, Fed Governor Lisa Cook has been accused of mortgage fraud and attacked in an attempt to get her to resign, possibly to get a more dovish voting member appointed to the committee. And a sitting member of the cabinet, from the White House Council of Economic Advisors, has just been confirmed to sit on the committee as a voting member. The inherent conflict of interest doesn’t seem to bother anyone.
Regardless, Chair Powell will be replaced early next year when his term expires. A steady hand will be required to replace him. But why are we seeing so much political attention to the federal reserve and what is the ultimate benefit of fed independence?
The concept of fed independence is simple enough. It is designed to shield the federal reserve and its voting open markets committee from the pressures of political whims. There is a two-fold intention here. The first is to isolate fed decisions from election cycles. The second is to provide credibility to the central bank by avoiding the zig zag action described above that could come from over steering the economy.
These concepts are not new. Why is the fed coming under fire now? A partial answer might be found looking at the makeup of the debt and the deficit. When the economy has been in crisis, the fed has used more than its basic tool, the fed funds rate, to address a sudden plunge in economic activity. Quantitative easing or QE has become a reliable secondary tool since the great financial crisis. This is when the central bank expands its balance sheet by buying bonds, becoming the buyer of last resort. It’s an effective tool, as it provides liquidity when it is likely to be scarce, but it has also led to massive debt overhangs. And this has placed a huge drag on current year budgets. Interest expense is now the 4th largest part of the federal budget. And that can be affected in a big way by interest rates. The higher they go, the bigger that piece of the pie gets.
From this perspective, it does make sense to try to keep interest rates in check. And most economists agree that lower interest rates are generally good for the economy. But the risk in oversteering in this case, besides a loss of credibility, is much higher inflation. This is the downside of low interest rates and we have seen the effects in the fed’s balance sheet during the decade of almost zero rates and the big pop in inflation following the pandemic.
Stormy seas are always on the horizon. It takes a steady hand to helm the ship through. Hopefully, the new fed chair will provide that steady hand and fed independence will prevail.
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