Politics, Policy, and the Power of the Fed

An important moment for the Federal Reserve

The Federal Reserve is the most important institution for the U.S. economy and financial markets. That’s not hyperbole. The thirteen independent voting members of the Fed are tasked with setting monetary policy intended to foster low inflation, support employment, and ensure financial system stability.  Its decisions shape the trajectory of our country’s economy. Occasionally, these goals conflict, leading to debates among investors and economists. September is one of those times.

The Chairman of the Federal Reserve, Jerome Powell, has recently indicated that disappointing employment data supports interest rate cuts. By adjusting the overnight lending rate between banks (known as the Fed Funds rate), the Federal Reserve influences broader financial conditions, including credit availability, consumer spending, and business investment, which ultimately impacts hiring decisions and employment. The risk, however, is that lower rates may reignite inflation, which peaked at a 9.1% growth rate in June 2022.

Behind the Scenes

The economy was still recovering from the implosion of the dot-com bubble in the summer of 2003 when Allen Greenspan, Federal Reserve Chairman, lowered rates to 1%, spurring an economic recovery and ultimately a real estate bubble.  Fed Chair Ben Bernanke followed suit after the Great Financial Crisis in 2008 with a series of quantitative easing which instilled confidence in investors and spurred a 15-year bull market.

Donald Trump has been vocal that he wants lower interest rates, believing that lower rates will stimulate the economy in the same way that Greenspan and Bernanke’s rate cuts set off economic booms. Lower rates may indeed spur economic activity, but they also run the risk of re-stoking the embers of inflation… or equally important, the expectations of inflation.

It’s important to remember that the Federal Reserve doesn’t control longer-term interest rates, such as mortgage rates and government bond yields, which are based on supply and demand dynamics shaped by expectations around inflation, growth, and risk.  If inflation expectations increase, it’s possible that the decrease in the Fed Funds rate (the only interest rate that the Federal Reserve controls) may lead to HIGHER long-term rates. The opposite impact of the intended policy move.

This may sound like a far-fetched risk, but it happened after the most recent rate cuts in 2024 when long-term rates increased by 100 basis points following a decline in the Fed Funds rate. Long-term rates also remained elevated following rate cuts in 1995, 1998, and 2007 as well, as indicated by the chart below. There are commonalities between those examples and today’s environment.  Those rate cuts occurred in non-recessionary times.  The stock market was near an all-time high in each case, as is the case today.

The investment implications of higher long-term rates aren’t necessarily catastrophic, but it would lead to higher borrowing costs for home buyers, higher financing costs for the US government, and a more restrictive borrowing environment for US companies, which typically issue longer-term bonds.  In other words, it may create the opposite impact of the intended rate cuts.

Broader Context

There is a broader context worth discussing. President Trump’s motivations are clear: he wants a Fed that supports his economic agenda, particularly by decreasing interest rates. As investors and policymakers await the Fed’s interest rate decision, it’s worth revisiting why the Fed’s independence is so vital and what history teaches us about the consequences of compromising it.

Throughout its history, the Federal Reserve has faced moments of intense scrutiny and challenge. In the early 1980s, Paul Volcker famously raised interest rates to double-digit levels to combat runaway inflation. His actions were deeply unpopular at the time, but they ultimately restored price stability and laid the foundation for decades of economic growth.

While the Fed’s structure is designed to insulate it from political influence, history shows that this independence can be tested. One of the most cited examples is Arthur Burns’ tenure as Fed Chair during the Nixon administration. Under pressure to keep rates low ahead of the 1972 election, Burns eventually relented, contributing to a surge in inflation that peaked at 13.5% in 1980. The episode damaged the Fed’s credibility and serves as a cautionary tale of what can happen when monetary policy becomes politicized.

Globally, we see examples of central banks that were influenced by politics in countries like Argentina and Turkey, which led to chronic inflation, currency instability, and loss of investor trust. These examples reinforce a simple but powerful principle: monetary policy works best when it is guided by data, expertise, and long-term goals rather than by political agendas or election cycles.

Investor Implications: Why Independence Matters

For investors, the independence of the Federal Reserve is not an abstract concept. If markets begin to doubt the Fed’s autonomy, long-term interest rates could rise as investors demand higher compensation for inflation risk and policy uncertainty. This would increase borrowing costs for consumers and businesses, potentially slowing growth and reducing equity valuations.

Moreover, compromised independence could lead to more volatile policy swings, making it harder for investors to plan and allocate capital. Stability and predictability are key ingredients for healthy financial markets, and they depend on a central bank that is trusted to act in the public’s best interest.

Conclusion: Between the Crosshairs

Investors, policymakers, and the public await the Fed’s decision. We suspect that the Fed will announce a 0.25% rate reduction, a seemingly inconsequential change in interest rates, but the decision and the language it may mark a turning point in monetary policy.  Will this mark the beginning of future rate cuts, setting off an economic boom?  Will the rate cuts lead to higher long-term, or perhaps higher inflation?  Regardless of the decision, it may take many months before we see the full impact of the policy decision. Make no mistake, we are at a turning point that historians may discuss in the years to come.

As always, we will continue to monitor the markets and make changes and recommendations as we see fit.  We appreciate your confidence and trust.  Please feel free to reach out with any questions or concerns.

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