What History Says Happens When the Fed Bends to a President’s Will

President Donald Trump and Federal Reserve Chair Jerome Powell have been at odds since Trump returned to power this year. (Photograph by Drew Angerer/Getty Images)

President Donald Trump has made his displeasure with Federal Reserve Chair Jerome Powell and his reluctance to cut interest rates well-known.

What’s less known is what has happened in the past when central bankers have been influenced by political leaders.

While Powell has stood firm, insisting that the Fed will make its decisions based on economic data, Trump maintains he’d like interest rates to be much lower, maybe around 1%. The main Fed rate has been on hold at 4.25% to 4.5% since December.

Trump wants low rates to bolster the economy, encourage job growth, and lower interest payments on government debt. And if those lower rates end up causing faster inflation later, it may well turn out to be a successor’s problem. Powell is resisting because of the uncertainty created by Trump’s tariffs, which may fan inflation later this year.

There may be more discussion of the outlook in the minutes of the last Fed decision, which will be published on Wednesday.

Trump isn’t the first politician to try to tell central bankers how to set interest rates, and he surely won’t be the last. But the last time a Fed chair followed instructions from a president, it didn’t end well.

Fifty years ago, President Richard Nixon famously leaned on Fed Chair Arthur Burns to keep interest rates low going into the 1972 presidential election. Though Burns and Nixon had a rocky relationship, historians say Burns and other Fed governors succumbed to the political pressure. That helped the economy grow and played a part in Nixon’s reelection that year.

But the decade that followed was difficult for the Fed. Low rates helped to strengthen inflation, and the Fed was already behind the curve when the Arab oil embargo hit in 1973. In 1980, U.S. inflation rates peaked at around 15%, and it took painful interest-rate increases and recession to get prices back under control.

Created with Highcharts 9.0.1U.S. Inflation RateSource: World Bank via St. Louis Fed

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The episode is a good illustration of why markets prefer central banks that are independent from politics. Elected officials will always be tempted to juice the economy with low rates before voters go to the polls. But politicians will also be punished if inflation picks up, and interest rates will eventually have to rise to prevent that.

Policymakers attempted to solve this problem by enshrining the independence of central banks, giving them a mandate to control inflation. By outsourcing monetary policy, politicians can usually take credit for a strong economy while not having to take the blame for unpopular interest-rate decisions.

For markets, an independent central bank means more confidence that inflation rates will stay low in the long term, which keeps bond yields down, and in turn allows governments to borrow money more cheaply than they otherwise would.

The argument in favor of independent central banks is perhaps strongest when illustrated by countries that don’t have them. In Turkey, for example, the inflation rates have been well into double digits for years. President Recep Erdogan argued the unorthodox case that higher interest rates actually fuel inflation. He appointed a central bank head to do his bidding, and inflation got worse. Eventually that policy was reversed, but annual price gains are still around 40%.

The U.S. is still a long way from that kind of situation, which is an extreme example. Despite Trump prodding Powell, and even suggesting he might appoint a successor early to undermine him, 10-year Treasury yields are still just above 4%. That’s higher than they’ve been most of the time since the 2008-09 financial crisis, but they are still normal historical levels. Bond traders clearly don’t expect U.S. inflation to be like Turkey’s any time soon.

But the decline of the dollar under Trump hints at a shift in perception of U.S. policies. The greenback has dropped 10% so far this year against a basket of peers, having had its worst first half since 1973—the year Nixon started his second term. That’s come as central banks in Europe have substantially lowered borrowing costs and Fed rates stayed unchanged—which, other things being equal, should imply that the dollar gets stronger.

Still, if the market sees the Fed as being susceptible to political pressure, it will start to assume that inflation rates are going to be higher. The Fed may well start cutting rates soon—markets are still pricing in a quarter point cut in September even after last week’s strong jobs report. The risk for Trump is that if traders view lower rates as a result of his influence, it won’t help him or the economy in the way he thinks it will.

Write to Brian Swint at brian.swint@barrons.com