WASHINGTON, Jan 19 (Reuters) – The most consequential test of the Federal Reserve’s independence in more than a century of existence comes before the U.S. Supreme Court this week, with the focus on whether the justices will shield the world’s most important central bank from political influence, as Congress intended, or allow President Donald Trump to clean house as he sees fit.
The case – revolving around Trump’s attempt to fire Fed Governor Lisa Cook over alleged mortgage fraud – could in the extreme erode that cherished independence, but even short of that result could provide the first roadmap for how a president can remove someone from the deeply insulated central bank governing body.
Even if Cook keeps her job, an outcome many legal analysts think is likely given prior Supreme Court statements about the Fed, the conservative-leaning court could lay out where Trump’s attempted firing falls short, and in doing so indicate what it takes to establish the “cause” needed to remove a monetary policymaker.
That requirement is set under the Federal Reserve Act and is meant to buffer Fed governors, including the powerful head of the central bank, from removal over disputes about interest rates, what Cook and more recently Fed Chair Jerome Powell argue is the real motivation behind Cook’s attempted firing and threatened criminal charges against Powell. Never before tested in court, analysts say putting flesh on that particular bone could confirm the central bank’s independence if the requirements are strict enough, but also give a creative administration a target to aim for.
“The door is open,” said former Cleveland Fed President Loretta Mester, now an adjunct professor at the University of Pennsylvania’s Wharton School of Business. “The question is how does it get resolved in a way that does not allow whoever is in the president’s office to just decide, okay, I don’t want that person, I will accuse them of doing something and that is enough.”
Cook argues that Trump did just that when last August, based on allegations she had misrepresented information on a home mortgage application, he said he was firing her from a Fed term that expires in 2038, far beyond the end of his presidency. No charges have been filed; no financial institution has accused her of fraud; there has been no administrative proceeding.
She sued and a lower court left her in her job pending a hearing – already a different outcome than in Trump’s moves to remake other ostensibly independent agencies. His administration appealed.
The Trump team’s argument, in effect, is that “cause” is whatever the president says it is, a standard that would seem to put Fed governors a whisker from being removed “at will.”
Jon Faust, a former top adviser to Powell and former Fed Chair Janet Yellen and now an economics professor at Johns Hopkins University, said he worried, given the Supreme Court’s support of the Trump administration on many other issues, that even if Cook is left in her job, the outcome will weaken the insulation from political pressure.
“I think the prospect of coming out with a strict and hard-to-clear hurdle is highly unlikely,” Faust said. “There is plenty of material for a narrow decision in (Cook’s) favor. … The battles will go on, Trump will continue the attacks, and if he chooses to use all his tools … it is highly likely that independence does crumble. I think we know the direction of travel.”
Others, however, remain hopeful.
“It does look like they’re going to try to carve out some exception that allows the Fed to maintain independence,” Kathryn Judge, a professor at Columbia Law School, said on Friday at a conference on Fed independence at Florida Atlantic University.
“But for that independence … to be effective, cause has to mean something, and there has to be some kind of meaningful limitation on the president’s ability to fire a governor on the basis of mere allegations.”
FED CREDIBILITY AT RISK
It is supposed to be hard to fire Fed governors, a principle reflected in the “cause” requirement and in their long, 14-year terms, even if few serve that long.
Monetary policy decisions can have painful short-term economic effects, to the detriment of elected officials wed to two- and four-year election cycles.
Former Fed Chair Paul Volcker used punishing, double-digit interest rates to break high inflation in the 1980s. The fallout? Twin recessions with unemployment rates topping 10% and remaining above 7% for about four years. Then-President Jimmy Carter, who appointed Volcker, lost his 1980 reelection bid amidst the economic malaise.
But the short-term pain reaped long-term benefits. By showing resolve to contain inflation, the Fed’s credibility got a boost, helping anchor public psychology – “inflation expectations” – in a way felt to still be helping temper inflation today.
The recent pandemic-era spike in prices never led to expectations moving dramatically out of line from the Fed’s 2% target. Researchers attribute that result to the credibility the central bank still had when it said it would return inflation to that level, and it is thought to have helped lower inflation without the recession many economists expected.
It’s that credibility, and its accompanying benefits, that’s at risk if monetary policy starts being tailored to political demands, the presumed outcome if presidents are able to fire Fed officials at will.
OUT OF PHASE WITH POLITICIANS
It all could work out. Presidents might accept high interest rates and slower growth as necessary when inflation threatens. Fed policymakers might set aside the risks to their jobs in that environment and make decisions based on the evidence, not the political mood.
The track record, however, isn’t good.
When the Fed’s past three chiefs, including the long-serving Alan Greenspan, signed a statement last week supporting Powell in the face of a U.S. Justice Department probe, it included this barb: The administration’s actions were reminiscent of “how monetary policy is made in emerging markets with weak institutions,” not in the institution overseeing inflation control for the world’s reserve currency.
Just as too-tight policy can needlessly slow growth and add to unemployment, too-loose policy pushes the economy beyond its productive capacity, lowering unemployment to an unsustainable level and driving up wages and prices.
Because it takes time for Fed decisions to impact the economy, central bankers are almost by definition out of phase with what politicians feel is appropriate in the moment.
“If you are not an independent central bank, inflation is higher, and it is higher by a lot. … That is reasonably well established,” said William English, a Yale School of Management professor and former head of the Fed’s monetary affairs division. “The benefits arrive up front. The costs arrive later, so there may be a temptation to ease policy and have lots of talk about the Trump boom and the inflation becomes somebody else’s problem.”
(Reporting by Howard Schneider; Editing by Dan Burns and Paul Simao)
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