The Illusion of Fed Independence

How fiscal pressures will continue to shape monetary policies even absent Donald Trump

Whenever Donald Trump criticizes the Federal Reserve, commentators rush to defend the Fed’s “independence.” But independence, like most things in Washington, is a slippery concept.

Two kinds of independence matter here. The Fed has what we might call operational independence, for lack of a better term: the ability to set interest rates and conduct monetary policy without daily interference from the White House or Treasury. Except for a stretch between 1933 and the 1951 Fed–Treasury Accord, the Fed has broadly enjoyed this kind of autonomy. What it has never had is economic independence. Fiscal policy – the borrowing and spending choices of Congress and the president – has always shaped the Fed’s room to maneuver. For the most part, we don’t notice this fiscal influence unless it creeps into fiscal-dominance territory (where we are now).

The Fed-Treasury Accord of 1951 is the key turning point. During World War II, the Fed pegged interest rates on Treasury bonds to keep government borrowing costs low. That arrangement persisted into the Korean War, even as inflation surged. By 1951, the Fed and Treasury were locked in open conflict: the Fed wanted to tighten policy to fight inflation, while the Treasury wanted cheap financing. The Accord ended the Fed’s obligation to hold rates down and restored its operational independence. In effect, that accord redefined the Fed’s primary job as managing inflation and the economy, not simply funding government debt.

And what about “political independence”? That phrase gets thrown around constantly, but it’s misleading. The Fed has never been outside politics. Governors are nominated by the president and confirmed by the Senate; Congress defines the bank’s legal mandate through the Federal Reserve Act. These are the channels of political accountability. When people worry about “political independence,” what they really mean is insulation from short-term partisan manipulation, and the dangers that come from presidents leaning on the Fed to juice the economy before an election, as Nixon did in the 1970s and as Trump has done more recently. In practice, “political independence” is less about being beyond politics and more about maintaining a norm of restraint.

Now it is worth noticing that for all the outrage we are hearing from everyone on what is happening with Trump and the Fed at present, very few people were bothered when Chairman Powell was urging Biden and Congress to pass lots of stimulus and Covid rescue bills during the pandemic and pledging to help as much as possible. In other words, depending on the circumstances, there is something of a double standard when it comes to the Fed's “independence.” Still, this reality doesn’t excuse Trump’s behavior.

The point is that no matter what people are saying or believing, monetary and fiscal policy are always bound together. The Fed can raise or lower rates, but the consequences show up immediately in the government’s budget: higher rates mean larger interest payments, lower rates make borrowing cheaper. Likewise, fiscal deficits and government-debt levels shape how far monetary policy can realistically go. When debt is high, tightening monetary policy quickly raises the government’s financing burden, creating pressure on the Fed to back off. When debt is low, as in the early 1980s, the Fed has more room to act boldly. In that sense, the fiscal authority is never absent from monetary policy. The two are permanently intertwined.

This is where fiscal dominance creeps in. I recently wrote the following on the issue:

“Fiscal dominance also occurs in the name of fiscal sustainability. Some economists, including me, have wondered whether there was more to the Fed's hesitation to raise interest rates when inflation took off in 2021 than a misread of a situation it called "transitory." The motivation for fiscal dominance was there. Then and now, higher interest rates mean higher interest payments, more borrowing and a higher deficit.

As University of Virginia economist Eric Leeper recently wrote, for the first time ever, the president is now making the connection explicit. Trump is demanding lower rates on the grounds that high interest payments on government debt are "costing taxpayers trillions." That's the textbook logic of fiscal dominance, and a return to the pre-1951 thinking.”

Chairman Volcker understood the connection well. In 1981, facing double-digit inflation, Fed Chair Paul Volcker didn’t just hike rates; he first told President Reagan that he wouldn’t change his monetary policy to accommodate fiscal pains (as he was pressured to do by Reagan’s Treasury secretary Donald Regan). In addition, he confronted Congress directly during testimony. “What is necessary,” Volcker told the House Budget Committee, “is that other policies — including most specifically the fiscal decisions that are the province of this Committee — be in harmony with the need to deal forcefully with inflation.”

In the end, Volcker prevailed. Fiscal consolidation eventually followed, through the Social Security commission of 1983 and a series of tax increases culminating under President Clinton. The message was clear: for disinflation to stick, fiscal policy had to align with monetary policy.

Today’s debt levels make any such alignment far harder. Interest payments already loom large, and the temptation to lean on the Fed is strong, as we see with Trump. Sadly, the temptation will not only persist after Trump leaves office, but it will intensify as our fiscal problems worsen.

That’s the long-term risk to Fed independence: not just presidential tweets or phone calls, but the quiet structural drift toward fiscal dominance, in which central banks serve fiscal needs rather than price stability. And that’s a risk no one talks about.

The bottom line: Fed independence has always been conditional. Operational independence was restored with the 1951 Accord, economic independence has never existed, and “political independence” is best understood as a fragile norm against partisan meddling. The danger now is that all of these conditions are tightening, with fiscal policy pulling monetary policy back into the fiscal orbit. If history is any guide, the Fed won’t escape that gravitational pull without a fight, and without Congress finally doing its part.