To understand why the politicization of the Federal Reserve is so problematic, let’s take a moment to understand the function and design of the Fed.
The Federal Reserve, established just over one-hundred years ago by the US Congress, is the nation’s central bank. The main responsibilities of the Federal Reserve, as identified in the Federal Reserve Act and subsequent legislation, are to promote the stability of the financial system and to ensure price stability and maximum sustainable employment. The main tool used by the Fed to accomplish the former goal is the supervision and regulation of banks. To achieve the latter goal – often called the Fed’s “dual mandate” – the Federal Reserve conducts monetary policy by influencing the real interest rate.
As a quick guide to how monetary policy works, when the main policymaking body of the Federal Reserve believes the economy’s main threats are high unemployment and slow GDP growth (as was the case in the immediate aftermath of both the 2008 US financial crisis and the COVID pandemic), the Federal Reserve reduces the real interest rate. The fall in the real interest rate reduces borrowing costs, prompting companies to increase their investment spending and consumers to purchase durable goods. The greater demand, in turn, promotes production and employment. If, on the other hand, the policymaking body believes that inflation is the economy’s main threat, then the Federal Reserve takes the opposite approach and raises the real interest rate. This change depresses demand, causing production and price growth to slow.
While the Federal Reserve was established by an act of Congress, is accountable to Congress, and members must periodically testify in front of Congress, the Federal Reserve is deliberately structured so that policymakers at the Fed remain largely independent from politics and political pressure. Among other design choices made with this intent in mind, the Federal Reserve is not funded through the normal Congressional budgetary process, members of the Board of Governors are appointed for 14-year terms, and members of the President’s administration are barred from serving on the Board. This independence gives the Federal Reserve the space to make hard economic decisions (like deliberately slowing the economy when inflation is too high) without direct pressure from politicians to reverse course.
And this brings us back to President Biden’s decision to re-nominate Jerome Powell as Chair of the Federal Reserve. If Biden chose to reject Powell in favor of a more politically-aligned candidate, it is possible that the monetary policy implemented by the new Chair would be slightly more conducive to President Biden’s agenda. (Even this possibility is not so clear, however, as a little over a year ago, Jerome Powell altered the strategic framework of the Federal Reserve in order to explicitly allow for greater average inflation, something that progressives have advocated for in the past.)
However, it is also possible that replacing Powell would help entrench a precedent whereby each President ousts the former Chair in favor of someone from his or her own political party. In doing so, the greater emphasis on the political affiliation of the Chair naturally diminishes the emphasis on the economic stance of the Chair. This politicization could, in turn, lead the Fed Chair to feel beholden to the President for their position, prompting policies that favor the current Presidential administration at the expense of a politically-neutral monetary policy. Would that Fed Chair be sufficiently independent to raise rates when the President demands the opposite, for example? This, in and of itself, would be damaging to the US economy. But, even if the Federal Reserve were in fact to remain insulated from political pressure, the mere semblance of the Federal Reserve choosing policies to support the current administration can itself be damaging. As detailed in my recent working paper with Professor Tortorice of the Department of Economics & Accounting, when the public questions the independence of the Federal Reserve, their expectations of future inflation rise. This belief makes it more difficult for the Federal Reserve to achieve both stable prices and maximum sustainable employment, thus undermining the Federal Reserve’s ability to achieve its legislated objectives.
In summary, when President Biden decided to re-nominate Jerome Powell as Chair of the Federal Reserve, the President likely acknowledged that the expected gain of a more-aligned Fed Chair paled in comparison to the long-term cost of potentially politicizing the Federal Reserve. This realization could have helped sway the President in favor of supporting Jerome Powell to remain Chair of the Federal Reserve.