MNI INTERVIEW: Political Pressure On Fed Risks Inflation Spike

Periods of elevated political pressure on the Federal Reserve to lower interest rates have often boosted inflation without doing much for economic growth. Now history risks repeating itself depending on how President Donald Trump’s efforts to influence the central bank play out, an economist at the University of Maryland who just published a paper on the issue told MNI. 

Thomas Drechsel recently authored “Political Pressure on the Fed," which finds that a six-month period of political pressure at half the level of that exerted by former President Richard Nixon would be enough to raise the price level by 7% over a ten-year period. 

“When a political pressure episode occurs, then we see an increase in prices and an increase in inflation expectations. Those increases are relatively gradual, they really build up slowly over time, but they become economically meaningfully large,” he said. “These effects on prices are not accompanied by a positive impact on real activity, which makes it very different from a typical policy easing.”

The research was based on a newly-created dataset measuring high-pressure interactions between the president and Federal Reserve chair, so Trump’s approach to influencing Fed policy – via public statements and social media posts – is not directly comparable, Drechsel said. But that doesn’t mean it’s not having an effect. 

“When Nixon met with Arthur Burns and pressured Arthur Burns, the public did get wind of that, and get an understanding of that, and that leads to these effects that I find. I'm less sure nowadays what kind of pressure is going on behind the scenes and in terms of personal interactions, but the public element of it, that's clearly there stronger than ever,” he said. 

HISTORICAL ECHOES

Drechsel said it’s possible that the lack of recent reaction to Fed cuts in economic output – and bond yields – is reminiscent of what happened in the 1970s, and could indicate Treasury market investors are sniffing out a political motivation behind the rate reductions. 

“If you and I understand that cut is political, we might worry about a generally softer Fed. If we are investors in long-term bonds, we might ask for a higher compensation because we think there might be more inflation baked into the system. I think that's what happened back then. It might be happening now too. It could be one of the potential mechanisms for why you don't see this output increase,” he said.  

“It might be that the market understands it – the Fed eases, but long term rates don't really ease. They even go up a bit, yeah, and that has a sort of tightening effect on financial markets, on certain kinds of credit, etc. That's possible.”

Drechsel said one reason bond investors might not have been more rebellious in the face of Trump’s attacks on Fed officials like Jerome Powell and Lisa Cook is that the institution is seen as more than the sum of its parts, and could resist even a Trump appointed chair that was aggressively dovish without backing from the data. (See MNI INTERVIEW: Fed Faces Politically Tumultuous Year - Bullard)

“There are still some protective layers there. In the end, it's a committee decision. That definitely matters. If the committee changes, and the administration is trying to change it, that has an impact, but it's still hard to fully change the entire FOMC,” he said.  

He noted that all candidates to replace Jerome Powell have, even as they argue for lower rates publicly, maintained the importance of Fed independence, and would likely be restrained by the remainder of the FOMC. 

“At least the discussion is still at a pretty coherent level and I think markets appreciate that," Drechsel said.