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President Trump is railing at the Federal Reserve: “I’m very unhappy with the Fed because Obama had zero interest rates,” he said last month. Previously, he claimed “the Fed has gone crazy” and is the “biggest risk” to the economy. The president’s criticisms call into question central bank independence. After all, why shouldn’t a critical, quasi-public institution answer to the nation’s elected officials?
The answer is that elected politicians have an incentive to create new money too rapidly. Easy money stimulates the economy temporarily by increasing spending and lowering unemployment. This enhances the re-election prospects of incumbent politicians, but over time the stimulus wears off and merely causes higher inflation. Independence allows the central bank to decide what money supply best suits the economy without undue pressure for inflation by short-term political interests. Abundant evidence shows countries with more independent central banks have less inflation.
After the recession in 2008, the Fed took unprecedented steps to stimulate the economy by creating new money and suppressing interest rates. This was appropriate back then to combat deflation. But now the economy has recovered. The unemployment rate is 3.7 percent, which is below a sustainable rate. And inflation is above target at 2.2 percent and rising. The Fed’s decision to gradually raise interest rates removes a stimulus that is no longer warranted—a stimulus that can’t lower unemployment much further but will raise inflation.
Interest rates are rising to normal and healthy levels. This is good for the economy, but frustrating for politicians as interest payments on the national debt increase. However, the Fed cannot create real resources out of nowhere for government to borrow. All it can do is redirect resources from the public to the government, either by reducing the purchasing power of money or by diverting lending away from private businesses. Central banks without independence are pressured by politicians to suppress interest rates to finance government debt. This obscures the cost of deficit spending but does not eliminate it.
The officials in charge of setting the governments’ budget should not be the same officials in control of the printing press.
Trump broke tradition by criticizing the Fed. That forced the Fed to demonstrate its independence. So much the better.•
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Bohanon and Curott are professors of economics at Ball State University. Send comments to ibjedit@ibj.com.
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