One of the most important Supreme Court decisions to come out this summer was the decision upholding the independence of the Federal Reserve Bank (often known as “the Fed”). At issue was whether President Donald Trump can fire Lisa Cook, a member of the Fed’s Board of Governors. Trump accused her of mortgage fraud but has not proven his claim. The Supreme Court ruling that came out recently did not say that she could never be fired, but that she could only be fired for cause and not simply on the President’s whim. This ruling makes the Federal Reserve different from other agencies, where the leader serves at the President’s will and can be fired without cause.
This is an important ruling because the independence of the Federal Reserve is the foundation of a stable economy. The Fed, which is the US’s central bank, has significant powers to determine what happens to the economy. We only have two different tools for steering the economy: fiscal policy and monetary policy. Fiscal policy is taxing and spending, and is controlled by Congress. Monetary policy is adjustments to the money supply through changes in interest rates, and is entirely in the hands of the Federal Reserve. Monetary policy has been, over the past half century, more important than fiscal policy, partly because monetary policy is more insulated from politics and thus can respond quickly and effectively to economic conditions.
The Federal Reserve’s power to create money and determine the level of interest rates is a valuable tool that can be used for good. On numerous occasions the Fed has used this power to stimulate a failing economy and get us out of a recession. However, this stimulus doesn’t come free. The cost of increasing the money supply is inflation. The only way to reduce inflation is to do the opposite: raise interest rates and reduce the growth of the money supply. The Fed is in a bind whenever both unemployment and inflation are high. It only has one tool; if it uses that tool to improve one of the problems, the other gets worse. If the Fed reduces interest rates, it will encourage growth of GDP but will also increase the inflation rate.
The Federal Reserve is not perfect. Its job is a bit like driving a car while only looking through the rear-view mirror. The Fed can only see the past but has to make policy for the future. It doesn’t always make the right decision; for example, it was too slow to raise interest rates after Covid,
resulting in the inflation of 2022. However, the Fed does the best it can with the information it has.
If a country’s central bank becomes politicized, the result is persistent inflation. An example is Argentina, which has had persistent inflation since World War II because the central bank was subject to government control. We also see that inflation ends when central bank decisions are no longer controlled by the government. Germany, Austria, Germany, Hungary, and Poland all experienced hyperinflation in the 1920s, and in all four countries giving the central bank power to say no to government requests for loans was an important part of stopping the hyperinflation.
There are two reasons why government power over monetary policy leads to inflation. The first is that the gains of money creation come in the short-run, while the costs (inflation) take longer to materialize. A government facing an election is tempted to provide a short-run stimulus if the costs will be borne only after the election. The second reason is that governments love to spend money and hate to tax because higher spending and lower taxes are always popular with voters. If the central bank is independent, then the government can only run deficits if someone if willing to buy their bonds. When the central bank is not independent, the bank’s money creation powers provide an infinite source of financing for government deficits. Whenever we observe hyperinflation, it is due to government deficits that are financed by money creation through loans from the central bank to the government. Central bank independence stops this by giving the bank the power to say no to requests from the government.
Since World War II, the US has had a well-functioning central bank, providing a good environment for growth with moderate or low inflation. That could end if the Fed loses its independence. While it might seem like board appointments are a minor issue, in fact the question of who appoints the board members is an important part of how central bank independence is measured. The Supreme Court ruling leaves open the possibility that Cook could be removed for cause. This means that the independence of the Federal Reserve is still in danger. If Cook is removed without having committed a crime, that will mean that the President can exert control over interest rates and the money supply, and price stability will be thing of the past.
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