DONALD Trump’s second administration has upended long-standing conventions in diplomacy, defence, fiscal policy, trade, public health, and more. Now the president’s “America First” policy is coming for the Federal Reserve. Critics led by Treasury Secretary Scott Bessent are challenging the central bank’s governance and its rate-setting models. Yet monetary policy is perhaps the one area in need of more revolutionary fervour than the White House appears to have in mind.
Kevin Warsh, a former Fed governor who is one of the candidates to replace Chair Jerome Powell next year, laid out the criticism of the central bank’s governance in April. Speaking to the Group of Thirty body of global financial policymakers, he accused the Fed of having stretched its statutory mandate of price stability and maximum employment into unwarranted political territory. Its purchases of US government debt under successive quantitative easing programmes had encroached on fiscal policy, Warsh claimed. By joining the Network of Central Banks and Supervisors for Greening the Financial System, it had gate-crashed energy and environmental policy. And by interpreting its full employment remit as “broad-based and inclusive” in August 2020 – suggesting that it might tolerate higher inflation in exchange for better employment rates for certain social groups – the Fed had veered into social policy too.
Bessent more recently added regulatory overreach to the charge sheet, tracing that aspect of what the US Treasury secretary terms the Fed’s “gain-of-function monetary policy” back to the Dodd-Frank Act, which overhauled bank regulation after the 2008 financial crisis. He was also explicit about the administration’s response. The Fed’s “overuse of nonstandard policies, mission creep, and institutional bloat”, Bessent wrote, will justify political intervention unless the institution reverts to its statutory mandate. The Fed, he warned, “has placed its own independence in jeopardy”.
These broadsides are certainly unusual. Against the backdrop of Trump’s public attacks on Powell and his attempts to unseat Governor Lisa Cook they also look ill-timed. One thing they are not, however, is revolutionary.
The distinction between policy – who sets the central bank’s mandate – and operational independence – who decides what measures they take to meet it – is entirely orthodox. Even an inflation target is a political choice, since changes in the price level redistribute wealth between savers and borrowers. Layer on social, environmental, and regulatory objectives and the need for political legitimacy is even stronger. Most modern central bankers recognise there is a trade-off between independence and breadth of mandate. The alternative would be a disconnect between bureaucratic power and democratic accountability.
Nevertheless, simply returning the Fed to its state in the early 2000s is a problematic idea. Even policymakers who were in charge at the time have acknowledged that the central bank’s narrow focus on inflation at the very least overlooked the bonanza of financial risk-taking that blew up the economy in 2008. Advocates of Hyman Minsky’s famous hypothesis that monetary stability breeds financial instability would say successful inflation-fighting was the single most important cause of the crisis.
Trump’s lieutenants also have their knives out for the models the central bank uses to set rates. The administration’s chief agitator on this front is Stephen Miran, the former hedge fund strategist who has taken a leave of absence as chair of the White House Council of Economic Advisers to occupy a seat on the Fed’s board.
In his first speech in the new job Miran last week berated the Fed for keeping monetary policy “very restrictive”. His core argument is that the central bank’s estimate of the interest rate which represents a neutral setting – the so-called “natural rate” or “r-star” – is mis-calibrated because its models underestimate the effects of the Trump administration’s other economic policies.
The war on illegal immigration, Miran argued, will slash population growth. Tariff revenue will cut the budget deficit. Tax cuts will boost growth, swelling the Treasury’s coffers further. The US$900 billion (RM3.8 trillion) of loans and guarantees pledged by trading partners in return for more lenient tariffs will turbo-charge the supply of loanable funds in the US.
These effects, Miran predicts, will raise net national savings, and the resulting glut of capital will push the natural rate of interest down some 1.3% compared to the pre-Trump era. That in turn implies that the Fed’s policy rate today should be closer to 2% than its current level of between 4% and 4.25%.
Yet while Miran’s calculations reach a radical – and even eccentric – conclusion, the theory behind them is once again startlingly conventional. The idea that the natural rate of interest in the US is low and under secular pressure to decline further was until recently the mainstream view of the economics profession. As far back as 2005 Ben Bernanke, then a Fed governor, ascribed it to a global savings glut. In 2019, former Treasury Secretary Larry Summers saw it as a symptom of “secular stagnation in the US itself. One famous 2017 study concluded that the natural rate had been declining since the 1990s because the premium to holding Treasury bonds had increased. Another from 2020 found the trend was international and went back centuries, and predicted natural rates might soon enter “permanently negative territory”.
The diversity of these explanations shows what’s wrong with Miran’s argument, however. It’s not that his views lack grounding in orthodox theory, but that the orthodox theory itself is hopelessly confused. The root problem is that the natural rate of interest is not actually observable: it exists only as a postulate of models which attempt to explain it. This has fuelled fierce debates over whether the underlying theory is in fact circular – and scepticism over whether the alleged movements in natural rates are real, rather than artefacts of the methods used to estimate them. The Bank for International Settlements concluded in 2017 that 150 years of data “raise questions about the theoretical, and above all practical, usefulness of the concept of the natural rate”. A recently published overview puts it even more bluntly. It muses whether the natural rate is not “simply a collective delusion of the economics profession”.
If Trump succeeds in establishing his authority over the Fed and installs governors who follow the president’s demands for lower policy rates, these debates may prove to be beside the point. Even so, the real problem with the current critiques of the Fed is not that they are excessively radical, but that they are not revolutionary enough.
Felix Martin is an economist, fund manager, and author. He writes for Reuters Breakingviews. The views expressed here are his own.