The Fed under pressure: Politics, power and the future of monetary policy

With the volatility in oil prices, combined with political pressures and the as yet unknown impact of AI, the Fed’s job becomes increasingly complex. And this has implications, both for everyday consumers and for markets.

So, is the Fed truly independent, has it ever been, and does it even matter?

Fed under pressure

Jerome Powell became the 16^th Chair of the Federal Reserve in 2018, appointed by Donald Trump during his first administration. Having been reappointed in 2022, his second term as Chair draws to a close in May this year.

While the appointment of a new Chair always draws scrutiny, this year has drawn more attention than usual, largely due to increasing fears of political interference in the independent central bank decision making process. As Trump took office, the US Fed funds rate was at 4.5%, a level which was subsequently held for eight months. During this time, President Trump has placed increasing pressure on the central bank to lower interest rates (which would stimulate economic growth, but would also potentially fuel higher inflation), from calling Powell names such as “numbskull” to threatening legal action over the Fed’s renovation project. He has also placed pressure on other governors, including threatening to fire Lisa Cook over alleged mortgage fraud.

Markets have grown concerned over the implications of a Fed which bows to political pressure. If bond markets perceive the Fed to be politically driven, they would likely demand higher long-term bond yields to compensate for the increased risk and economic implications of loose monetary policy, manifesting itself in a steepening of the yield curve.

Independent – to what extent?

The fears of a politicised Fed assume that the central bank is currently independent.

Originally founded in 1913 to establish a monetary framework to respond to stresses in the banking system, before its mandate evolved in 1977 to promote maximum employment and stable prices. It has been considered independent since the Treasury-Fed Accord in 1951, when the US Treasury and the Fed reached an agreement to separate government debt management from monetary policy. This has long been seen as essential to guard monetary policy from being influenced by short-term electoral cycles, allowing the Fed to focus on long-term price stability.

However, it could be argued that the central bank is only independent when it is of no consequence. But in times of crisis, the government and the central banks tend to coordinate. For example, the two most recent global crises, the Global Financial Crisis and Covid, saw a closely coordinated central bank and government response in order to manage the impact and stimulate the economy. In these instances, the response went beyond politics to mitigate global challenges that could have had potentially catastrophic impacts on a much broader cohort.

Does independence matter?

While Trump’s political motive may be to reduce interest rates to drive economic growth, ultimately he will be constrained by the electorate. Cost of living has become a big political issue since the 2022 inflationary bout. It is likely that if a politician were to dictate interest rates, the electorate would not thank them for generating inflation. The power of the electorate creates a political imperative to keep inflation under control, aligning the political and central bank objectives. We have seen this in Japan, where the population grew accustomed to inflation and interest rates being near zero. The rapid rise in the cost of living between 2022 and 2024 led, in part, to voter dissatisfaction, resulting in the end of the Liberal Democratic Party’s 15-year majority in October 2024.

Furthermore, there is an argument that the central bank is becoming increasingly politicised with or without Trump – as a function of the US’s rising debt levels. As public debt-to-GDP has ballooned in the US, so have its debt servicing costs – with interest servicing costs surpassing Defense and Medicaid in terms of government spending. Even without pressure from Trump, the Fed is somewhat limited in how far they can raise interest rates before the interest costs on US government debt becomes untenable. It may be the case going forward that beyond price stability and employment, the Fed has to take into account the state of government balance sheets when making monetary decisions.

What does the future hold?

Politicisation aside, the Fed faces an uphill battle. While never straightforward, the central bank’s job has been complicated by a barrage of conflicting forces.

While it has been largely assumed since the conflict with Iran began that the spike in oil price will cause an inflationary shock, this may not be the case. Comparisons with the oil shock in 2022 have been drawn but that was a period of significant liquidity as a result of the fiscal and monetary response to the Covid pandemic. Today’s oil shock hits the economy following a period of monetary tightening, meaning that households and businesses may find it harder to absorb higher energy costs, low growth environment. The uncertainty over how this will play out, combined with the memory of 2022 when the Fed was slow to react to inflationary pressures, creates complexity for the central bank.

Before the outbreak of the war, the question at the front of central banks’, and investors, minds was the likely impact of the artificial intelligence (AI) boom on jobs and inflation. There are fears that while AI could result in productivity gains, it may also place downward pressure on wage growth as displaced workers compete for jobs. If there is a mass displacement of jobs as some have predicted, this very much factors into the Fed’s maximum employment mandate and require lower interest rates.

Independent or not – the Federal Reserve plays a crucial role in society and markets and will continue to do so.