Is the Federal Reserve Truly Independent?

The Federal Reserve building in Washington, on Oct. 22, 2021. (Daniel Slim/AFP via Getty Images)

Commentary 

There are presently five open slots on the Federal Open Market Committee (FOMC), the policymaking body for the Federal Reserve system. These are vacant because of political disagreements in the Senate. President Joe Biden has nominated someone for each seat, while last month Republicans on the Banking Committee called a halt to every one of the five over strenuous objections to one (Sarah Bloom Raskin) in particular.

Among the stranded nominations is that for current Federal Reserve Chairman Jerome Powell seeking his second four-year term atop the agency. This is a particularly inconvenient time for the supposedly independent central bank. Next Tuesday and Wednesday, the FOMC will get together and vote on what is certain to be the first rate hike since December 2018.

Following several years of holding its monetary targets at and near the zero nominal level, while simultaneously conducting its largest program of so-called quantitative easing yet, the Fed is now under severe political pressure to do something about consumer prices.

The public has, erroneously, linked the acceleration in them to the Federal Reserve’s policies; quantitative easing, or QE, has been constantly singled-out as objectionable “money printing.” Combined with low policy target rates, the Fed’s position has been uniformly characterized as highly accommodative.

Too accommodative, according to its many critics (not just those from the opposition party in Congress).

With gasoline prices surging even more than they had leading up to now, thanks, in part, to fallout in oil markets from Russia/Ukraine, congressional Democrats are already feeling the pressure from constituents who are understandably and honestly angry about paying so much for gas at the pump. The November mid-term elections are now less than a half-year away.

For politicians, the easy answer is to pressure the Federal Reserve into reversing its prior “accommodative” course. If voters think the Fed’s QE and zero-rates contributed much or all to their current price pain, then using five stalled nominations as leverage might not be some conspiracy theory.

After all, for most politicians, of either party, the immediate goal is essentially to appease the distraught electorate by appearing to do something about their primary concerns. Even before seeking Senate confirmation, Powell’s FOMC had already scaled back its prior QE, and next week voting to raise its target policy rates certainly further qualifies—for appearances sake.

The wider decidedly non-political question is whether or not this would make any difference to oil prices or the economic situation in general. In truth, there’s as much realistic downside to rate hikes as any possible ground gained back from crude.

Hiking policy rates cannot make oil producers produce more oil, nor will they somehow greatly increase West Coast port capacities still struggling to handle last year’s uptick in goods imported.

Our problem with consumer prices isn’t money, largely because the Federal Reserve didn’t print any (and actually can’t, at least not what’s useful to the financial system and thereby the economy-at-large). No one is actually trying to tackle this system-wide price shock due to constrained supply and transportation by shutting down QE and then modestly hiking policy rates.

That’s political theater.

But in being forced to engage as such, conceding to political pressure, the Fed risks further upsetting the one venue where its operations do bear consistent fruit: the stock market. Most people are likely familiar with the cliché about policymakers taking away punch bowls, spoiling the excessive partying in equities by turning “hawkish,” as the FOMC is about to in mere days.

While there is no truth to it in literal monetary terms, psychology is another matter entirely. If investors and speculators believe that they have “accommodative” central bank policies supporting their risk-taking, they will act, have acted as if that is the case, buying up shares seemingly without regard for price.

Take away that belief, or just changing the expression about the policies, and suddenly the risks behind highly-priced shares seem quite different.

Policymakers famously rely on the stock market to signal only good things about both their efforts and the positive economic picture high investment valuations might send, in theory, to consumers and businesses. Thus, on the one hand the politics and supply constraints bubbling up in costly oil, but on the other a widely noticeable stumble on Wall Street that actually could reverberate onto Main Street.

Unbeknownst to most, credit markets are already pricing these doubts with increasing confidence—that rate hikes once begun may not actually stick around for very long. Should stocks continue to struggle, that’s the one factor most likely to change the official tune.

The other is what might actually be bugging Wall Street and the bond market alike. The higher oil prices go, the more likely the economy suffers from something called demand destruction. Quite simply, the more consumers pay for gas or groceries the less they’ll have to spend on other things, especially services, and the less they are likely to spend overall.

Business profitability suffers greatly, too.

This is not some hypothetical distant possibility; rather, a key part of the credit market, something called eurodollar futures, is already pricing a substantial likelihood for this scenario. The eurodollar futures “curve” is a bet on future short-term money rates linked to the Federal Reserve’s policy targets.

With this curve inverted, having turned upside down way back on Dec. 1, we interpret that inversion as an alarmingly high level of confidence for money rates to stop rising, the Fed halting its rate hikes long before currently anticipated in the mainstream consensus.

Not only that, the inversion has grown so much there’s a serious chance the FOMC might have to actually turn around and begin reducing its policy targets at some point.

What kind of economic scenario might lead to something like that happening? Demand destruction tops the list, alongside several more technical real money factors well beyond the Fed’s truly limited capacities.

And it’s not just eurodollar futures where this darkening potential has been gaining substantial traction for months already. The U.S. Treasury yield curve along with other more sophisticated markets like those for interest rate swaps are currently priced in near lockstep agreement with these worrisome possibilities extracted from the eurodollar futures inversion.

Powell’s policies once said to have been highly accommodative are not being priced that way, and, in truth, never were. The markets have been resolute about such money theater being just that, more theater.

Should demand destruction occur, oil prices won’t stay up for long, either.

How committed is the Fed to rate hikes? The markets are betting however much policymakers are right now, it’s for melodramatically partisan reasons. So much for independence.