Cooking the Federal Reserve’s Credibility

Did Wile E. Coyote just make a cameo appearance?

After markets closed Wednesday, financial news sites were full of talk about a “global bond rout.” The headlines were over the top: long-term interest rates were up, but not all that much. Call it “Apocalypse Not Yet”. And as I write this, rates have retreated again in the aftermath of a jobs report that strongly suggests a weakening labor market.

Still, market movements since Donald Trump announced that he was (probably illegally) firing Lisa Cook from the Federal Reserve’s Board of Governors offer a preview of what to expect if the courts allow Trump to destroy the Fed’s independence. Spoiler: Not good.

Trump began his effort to replace Cook on Friday, Aug. 25, after the markets had closed. Below is a graph of the probability that Trump will succeed assigned by betting markets. After a sharp uptick on August 25^th, the probability dropped down to around 30%, reflecting a belief that he will probably fail. However, it’s important to note that a 30% probability is not trivial.

Chart 1

If Trump does succeed in firing Cook, it would be a step on the road toward a fully Trumpified monetary policy.

What would happen if Trump gained control of the Fed?

He would be able to push through large cuts in the Federal funds rate, the short-term interest rate on overnight loans banks make to each other. And I mean large: he’s been talking 300 basis points. We have in the past seen rate cuts that big, but only in the face of serious recessions. Trump, however, insists that the U.S. economy is booming, and a cut that big in the absence of a recession — and with inflation both above target and set to rise due to tariffs, deportations and surging electricity prices — would be unprecedented.

Standard economics says that a big Fed funds rate cut in the absence of a severe economic slump would be inflationary. It would also damage the Fed’s credibility — investors’ belief that it will do what is necessary to fight future inflation. Eventually, however, inflation would force even a Trumpified Fed to raise rates.

What would you expect to see in bond markets if investors put a high probability on Trumpification of the Federal Reserve? You would expect short-term interest rates, which mainly reflect expectations about Fed policy over the next one to two years, to fall. But very long-term rates, which mainly reflect expectations about long run inflation, should rise. So what did we see between Aug. 25 and Sept. 2? Two-year rates fell by 7 basis points, while 30-year yields rose by the same amount.

Granted, these weren’t huge moves, reflecting the markets’ belief that Trump is unlikely to be able to fire Cook. Yet, this was a cameo appearance by Wile E. Coyote. The divergence between short-term rates and long-term rates was a reminder that Trump’s move to undermine the Federal Reserve’s independence is a real threat to the Fed’s credibility. And that matters.

At the Federal Reserve’s most recent Jackson Hole conference — its annual shindig in the Grand Tetons — Emi Nakamura, Venance Riblier and Jón Steinsson presented a paper on the effects of central bank credibility, as indicated by the ability of the Fed and its counterparts to ‘‘look through“ post-Covid inflation, allowing the temporary inflation surge caused by supply chain disruptions to work itself out without needing to impose high unemployment.

Specifically, they looked at the ability of central banks to temporarily deviate from the Taylor rule, a basis for interest rate policy initially suggested by the economist John Taylor in a 1993 paper. Taylor argued that when responding to tradeoffs between inflation and unemployment, the Fed shouldn‘t fly by the seat of its pants; it should commit in advance to a specific rule linking interest rates to the inflation rate and the unemployment rate or some other measure of economic slack.

The Fed has never explicitly adopted a Taylor rule — I say “a“ rule because there are a number of variants on Taylor‘s original suggestion, similar in principle but differing in the details. The Atlanta Fed has a “Taylor Rule Utility“ that incorporates a number of popular versions: pick your rule and it tells you what the Fed funds rate will be.

Still, various rules tend to give similar guidance. And the Taylor rule has proved highly influential as a sort of baseline or norm: The Fed doesn‘t want to deviate too far from the rule without very good reason.

In 2021-22 the Fed thought that it did, in fact, have a good reason not to follow the Taylor rule. Inflation was very high, and a Taylor rule would have called for very high interest rates to match. But the Fed believed that the inflation surge was temporary, driven by post-Covid supply chain disruptions, so it held off on raising rates. Here‘s what a Taylor rule (FOMCTaylor99UR, if you want to know, which you don‘t) said, versus what the Fed actually did:

Chart 2 Source: Federal Reserve Bank of Atlanta

The Fed was harshly criticized by many economists for waiting to raise the Fed funds rate, and there were many dire warnings that the Fed would have to put the economy through years of high unemployment to get inflation back under control.

Self-promotion alert: I didn‘t join that chorus. On the contrary, I argued that getting inflation down would not require an extended slump.

And it didn‘t. Chart 3, lifted from my first primer on stagflation, shows that the disinflation of 2022-2024 was nothing like the painful disinflation that followed the 1970s, involving almost no cost in higher unemployment.

Chart 3 Source: Bureau of Labor Statistics

What Nakamura et al showed was that the Fed was able to pull off the feat of taming inflation without putting the economy through a recession — in other words, to “look through” supply chain inflation — because of the credibility it had acquired over decades of monetary independence.

And Trump is trying to throw all of that away.

One more thing. Look back at Chart 2. Again, this chart compares the actual Fed funds rate with the rate recommended by a rule that has proved useful in the past. And right now the actual and recommended rates are about the same. So why is Trump demanding a huge cut in interest rates?

Nobody really knows. He may think lower interest rates will make him more popular. He may think of low interest rates as a reward for good performance — and in his mind the economy is doing great, he may want to reduce the budget deficit by cutting federal borrowing costs.

Whatever he’s thinking, if he succeeds in trashing the Fed’s independence, he won’t like the results. He might succeed in pushing short-term rates down for a while. But the interest rates that really matter to people’s lives are long-term — like mortgage rates. And Trumpifying the Fed, thereby destroying its credibility, will send long-term rates higher — maybe much higher.

MAGA!

MUSICAL CODA