How The Federal Reserve Can Maintain Its Independence

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Wharton’s David Zaring and MSU’s Lisa Cook discuss the future of the Federal Reserve.

Federal Reserve chair Janet Yellen is facing a delicate balancing act amid pressure from the Trump administration that some feel could undermine the Fed’s independence, even as she may be willing to concede some ground in reviewing financial regulations.

Federal Reserve

In testimony to Congress on February 14 and 15, Yellen gave no major hints about a possible interest rate increase at the next Federal Open Market Committee (FOMC) meeting on March 14-15. She did say that she expects “the evolution of the economy to warrant further gradual increases in the federal funds rate,” as “waiting too long to remove accommodation would be unwise.” However, she made it clear that “monetary policy is not on a preset course” and economic data would guide future rate actions.

“One thing that is not clear from statements [President Donald Trump] has made in the past is that he understands what independence of the institutions means — whether it is the judiciary or the Federal Reserve,” said Lisa Cook, professor of economics and international relations at Michigan State University. “We absolutely have to guard this independence. That is what has gotten us out of the recession — let’s be clear — because Congress abdicated its responsibility for fiscal stimulus. The Fed has been doing all the heavy lifting getting us out of the recession.”

Rumors of Yellen’s departure from her office before her term ends in 2018, which Yellen herself has denied, have raised concerns over Trump’s ability to influence monetary policy and regulation in the long run. Irrespective of what Yellen decides, Trump will get to have his way in other places in the monetary policy-making and regulatory establishment, according to David Zaring, Wharton professor of legal studies and business ethics. “Even if she doesn’t [leave], the President is going to have a real chance to remake the Fed,” he said.

Zaring pointed to the need to replace Daniel Tarullo, a Federal Reserve board member who is widely credited with leading financial regulation after the 2008 recession. Tarullo resigned last week, but will stay on until early April. That means Trump must fill a total of three vacancies on the Fed’s Board of Governors. Like Yellen, Fed vice chair Stanley Fischer also completes his term in 2018. Similarly, three of five commissioner spots are vacant at the Securities and Exchange Commission, following the voluntary departure on January 20 of chairwoman Mary Jo White. Many heads of divisions at that agency have also quit, Zaring said. “So there is a lot of work to be done in re-staffing financial regulators. And staffing choices really can make a huge difference.”

Cook and Zaring discussed the emerging contours of the Fed’s independence, interest rates and financial regulation on the Knowledge@Wharton show on Wharton Business Radio on SiriusXM channel 111. (Listen to the podcast at the top of this page.)

Whither Interest Rates?

The most immediate speculation is over how Yellen and the FOMC will act on interest rates. “[Yellen] was as cautious as she has been and can be,” Cook said of the Fed chair’s congressional testimony. “They have three quarter-point rate hikes that are penciled in. She is in no hurry for those hikes to proceed if the data are not there, especially with respect to increased uncertainty in the economic data.” That data would cover the period after the presidential inauguration “or since some of these policies have been introduced or at least alluded to,” she added, underlining the direct impact of the Trump administration on economic growth. “A lot of uncertainty has been introduced, and this will make all of the members of the FOMC be more cautious.” However, Cook noted that a third of the economists who have been surveyed “suggest that there will be a rate hike in March.”

“Even if [Yellen] doesn’t [leave], the President is going to have a real chance to remake the Fed.”–David Zaring

Wharton finance professor Krista Schwarz also agreed with Yellen’s cautious approach to raising rates. “Many have been arguing for a long time that the Fed has set rates too low,” she said. Schwarz, who previously worked for the Fed, pointed out that inflation is “still too low” and the economy seems to be “very close” to full employment. She predicted that the Fed “will pick up the pace of tightening a little bit this year” while Yellen monitors economic data. “But they will not raise rates sharply unless and until they actually see signs of an inflationary problem in hard data.”

Schwarz said the shifting positions of advocates of higher interest rates make a decision more difficult. “Those arguing for much higher rates seem to constantly change the rationale,” she explained. “Sometimes it is inflation, sometimes it is financial stability, sometimes it is fiscal policy, and sometimes it is just [about] wanting banks to be more profitable. The morphing rationale brings these arguments into even greater question.”

Easing Cash Flows

In her testimony, Yellen rejected the idea that excessive regulation has hampered bank lending. “I see well-capitalized banks that are regarded as safe, strong and sound,” and they are “capturing market share,” she told the Senate Banking Committee earlier this week. Zaring said many in the political establishment do not share that view, and referred to Massachusetts Sen. Elizabeth Warren’s comment that banks aren’t lending enough and that it is hurting small businesses. Also, corporate America and Wall Street are complaining that it is hard to obtain financing in the bond market, he noted. “All of these people suggest that credit is difficult,” he said. “It is interesting to see the Fed say that they don’t seem to agree, or Janet Yellen isn’t willing to go there.”

Such complaints about lending are not new, said Cook. “Banks always say they could use more money and firms always say they could use more money,” she said, referring to her surveys of banks and firms over the past two or three decades.

“A central bank’s independence is the cornerstone of its ability to execute effective monetary policy.”–Krista Schwarz

Cook pointed to payment delays as a serious factor that causes a liquidity crunch for small businesses, and she called for some form of government intervention to unclog those pipelines. She recalled that during 2011-2012, suppliers were slowing down payments to small businesses. “This kind of cash crunch can have a significant effect on a small business,” she said. “That’s a margin along which there can be some action — some sort of governmental intervention.” She said the government could ensure that small businesses that are government contractors are paid in a more timely fashion. The objective should be to get payments made within 30 days, “but veering away from what was creeping up to be 180 days for many suppliers.”

Small businesses do not have the cash flow to accommodate payments that are held up for 180 days or longer, Cook said. She recalled that during the last government shutdown (in September-October 2013), providers of government services that were privatized didn’t get paid because there was no work during that time period. Some of