Why Investors Should Care
In a fiat monetary system, central bank credibility is the anchor for inflation expectations. When that credibility is weakened by political pressure, the effects are not always immediate, but they are significant for investors over time.
Investors should care about Federal Reserve independence because:
- Inflation expectations influence interest rates, valuations, and long-term returns
- Political interference increases uncertainty around monetary policy
- Loss of credibility has historically led to higher inflation and prolonged economic instability
- These risks often develop gradually and are not immediately reflected in market prices
Key Takeaways for Investors
- Federal Reserve independence matters most when markets appear calm
- Inflation expectations shape asset prices across stocks, bonds, and currencies
- Restoring credibility after it is lost is costly and often requires economic contraction
- Long-term investors benefit from understanding institutional risks before they show up in returns
For a deeper explanation of how inflation expectations influence interest rates and long-term returns, see Inflation Expectations and Interest Rates: What Investors Should Understand.
Recent Events and Market Reaction
Earlier in the month, US prosecutors launched a criminal investigation into Jay Powell’s handling of a major renovation of several Fed buildings in Washington, D.C. The investigation is just the latest in a series of actions against the Fed.
Markets have been remarkably calm. Gold and silver prices were up, the dollar was down slightly against a basket of major currencies, and the ten-year bond yield was slightly higher. The major stock indices have been volatile but seem to be continuing their upward climb. With markets remaining so confident, does Fed independence even matter?
Political Pressure and Monetary Policy
I can’t comment on the legal merits of the charges, which center around testimony the Fed Chair gave to Congress last year about the renovations. The president has been openly critical of Powell, calling him a “numbskull” and “stubborn mule.” The president has also tried to fire Fed Governor Lisa Cook before the action was overturned by a lower court. At the time of this writing, the issue is being heard by the Supreme Court. Given recent history, this looks like the latest attempt to give the executive branch influence over monetary policy. And that seems to be the take of Powell himself, went he put out a video denouncing the investigation as
“… a consequence of the Federal Reserve setting interest rates based on our best assessment of what will serve the public, rather than following the preferences of the President.”
The Federal Funds Rate Debate
The president has decided that the Federal Reserve’s key policy rate, the federal funds rate, should be 1%. Where he is getting this number, nobody knows. Inflation has been running above the Fed’s 2% target and longer-term interest rates. Even if inflation were to come down to the Fed’s 2% target, a 1% federal funds rate would mean that the real rate (adjusted for inflation) would be negative 1%. It is not a stretch to imagine that such a policy would be inflationary.
How Policy Is Actually Set
It’s possible that markets don’t really think the president will get what he wants. Even if the next Fed Chair is a die-hard loyalist, policy is set by the entire 12-member FOMC. Except for Stephen Miran, who is currently serving on the Board of Governors while on leave from the President’s Council of Economic Advisors, the other board governors and bank presidents have shown their independence.
Whether the president’s arguments have economic merit is beside the point. The Fed’s mandate is to maintain price stability and promote full employment. The Federal Open Market Committee (FOMC), the body within the Fed that sets monetary policy, must try to balance these two goals. There are differing opinions among the voting members as to what the federal funds rate should be. For better or worse, monetary policy relies on discretion. Different people will have different opinions. But the president’s opinion, stately publicly, probably should not be among them.
Why Fed Independence Matters
That brings us back to the original question: does Fed independence really matter?
The short answer is yes. The reason why is that in a fiat monetary system, central bank independence is the only thing keeping inflation expectations in check. If inflation expectations increase, interest rates and consumer prices will rise. Foreign holders of dollars would dump them for stabler stores of value. I don’t think these outcomes are desirable for anyone.
A Brief History of the U.S. Monetary System
To see why Fed independence is so important, it helps to briefly look at the history of the US central bank.
The Gold Standard Era
At the beginning of the twentieth century, the US, like all major countries, was on a gold standard. Under a gold standard, currency is convertible to gold at a specified exchange rate.
The US formally enacted a gold standard with the passage of The Gold Standard Act of 1900. The act defined a dollar as equivalent to 25.8 grains of 90% pure gold, which equated to a dollar-gold exchange rate of $20.67 per ounce. Under this system, the money supply is limited by the amount of gold held in the banking system.
Creation of the Federal Reserve
The Federal Reserve was created in 1913 as a response to banking panics in the late 1800s and early 1900s. When the Federal Reserve Act was signed in December of 1913, the legislation contained no mention of “price stability.” This was not an oversight. The architects of the legislation expected the newly created central bank to implement its policies consistent with the gold standard. The act required the Fed to hold gold equal to a minimum of 40% of the total currency issue. Gold, in other words, acted as a nominal anchor – a constraint on the value of domestic money.
But it turned out that gold was too much of a constraint. When credit collapsed in the late 1920s and early 1930s, the Federal Reserve did little to alleviate the collapse in the money supply and the fall in prices. Many economists believe that the fed’s attempt to protect its gold stocks at least contributed to its inactions during the depression.
Roosevelt and Treasury Control
In early 1933, the US banking system faced massive redemptions of gold, both from domestic and foreign depositors. The incoming Roosevelt administration, in an attempt to reverse the monetary collapse, suspended gold convertibility, made private ownership of gold illegal, and restricted the flow of gold outside the US.
Later in 1933, Roosevelt ordered the Reconstruction Finance Corporation – an agency established in 1932 to provide emergency lending to the banking system – to purchase newly mined gold at increasingly higher prices. Roosevelt was also given authority under the 1933 Agricultural Adjustment Act to reduce the gold content of the US dollar. Roosevelt would use this authority the next year with the passage of the Gold Reserve Act of 1934. With the Gold Reserve Act, Roosevelt reduced the gold content of the dollar from 25.8 grains of 90% pure to 15 5/21 (approx. 15.24) grains of 90% pure. This increased the dollar price of an ounce of gold from $20.67 to $35. The Gold Reserve Act also transferred all monetary gold from the Federal Reserve banks into the US treasury.
The collective impact of Roosevelt’s gold policies was to effectively put the Treasury in control of monetary policy, despite modifications to the Fed’s governing structure in 1935 which revamped the Federal Reserve Board and removed the treasury secretary and comptroller of the currency from the Board.
World War II and the Treasury-Fed Conflict
The Fed’s subordination to the US treasury became even more pronounced during WW2. Like most wars, WW2 was financed by a combination of taxes, domestic borrowing, and inflationary finance (i.e., money printing). The Federal Reserve committed to purchasing war bonds at interest rates significantly below prewar rates. Another consequence of the war was an even greater surge in gold imports to the US from Europe. The combination of an increased gold supply and a surge in the Fed’s bond buying led to a sharp increase in the money supply. The government kept inflationary pressures at bay through a combination of price controls and restrictions on consumer credit. But the controls had to eventually be removed, unleashing a sharp increase in prices in the late 1940s.
By this time, the Fed was looking to free itself from its arrangement with the US Treasury by breaking with its commitment to the wartime interest rate ceiling. But the Treasury insisted that the Fed maintain the interest rate peg, especially given that another war was about the breakout in Korea. What the central bankers at the Fed wanted was the independence to fight inflation and react to recessions. Conflict between the treasury and the Fed was inevitable.
The Treasury-Fed Accord
The back and forth that arose with President Truman and Treasury Secretary John Snyder on the one end and Fed Chairman Thomas McCabe and Fed Governor Marriner Eccles on the other. The conflict led to President Truman inviting the entire Federal Open Market Committee to the White House. Truman and Snyder tried to get the FOMC to agree to the accommodation, but the group refused. Despite the FOMC’s refusal to commit, the White House put out a press statement indicating that the FOMC had pledged to support the government bond market throughout the conflict. Enraged, Marriner Eccles released the FOMC’s account of the meeting.
With the Fed unwilling to budge, the Treasury had no choice but to work to end the public dispute. Assistant Secretary William McChesney Martin met with several Fed officials to negotiate a compromise. The Fed agreed to temporarily support the price of five-year notes but would no longer support the interest rate peg thereafter. On March 4, 1951, the Treasury and Federal Reserve put out a joint statement saying they had
“… reached full accord with respect to debt management and monetary policies to be pursued in furthering their common purpose and to assure the successful financing of the government’s requirements and, at the same time, to minimize monetization of the public debt.”
The above statement became known as the Treasury-Fed Accord. As innocuous as the statement reads, it is seen by many economists as the beginning of the independence of the modern Fed, at least insofar as it distanced the Fed from the financing needs of the government.
From Bretton Woods to Fiat Money
Later in the year, President Truman appointed William McChesney Martin, the assistant treasury secretary, to Chair the Federal Reserve. Truman assumed that someone from the administration serving at the Fed would be more accommodating, but Martin proved to be a capable and independent Fed Chair. He served from 1951 to 1970.
It is important to recognize that in the 50s and 60s, gold remained a component of US policy monetary. Gold’s revised role in the monetary system was established in 1944, when delegates from forty-four nations met in Bretton-Woods, New Hampshire to negotiate a post-war international monetary arrangement. The system that they agreed to, known as the Bretton-Woods System, placed the US dollar at its center, with other participating countries fixing their currencies to the dollar at specified exchange rates. In turn, foreign governments and central banks could convert their dollar holdings to gold at the rate of $35 per ounce.
The Bretton-Woods system was short-lived. The system did not become operational until the mid-1950s. By the mid-1960s, foreign-held dollar claims greatly exceeded US gold stocks. Increases in US fiscal spending resulting from the Vietnam war and The Great Society programs led to increased deficits and further eroded confidence in the dollar. Even with inflation creeping up, Johnson pressured Chairman Martin to lower interest rates, reportingly even pushing Martin up against a wall during one encounter.
The Inflationary 1970s and the Volcker Era
Martin was the longest serving Chair in the history of the Fed (beating Alan Greenspan by a few months). When his final term expired in January of 1970, President Richard Nixon appointed Arthur Burns as his replacement.
By this time, inflation had been creeping up for several years and foreign governments and central banks were losing confidence in the dollar. By the summer of 1971, the US was facing a full scale run on the dollar. In August of 1971, Richard Nixon convened a meeting with his top economic advisers at Camp David to discuss the looming economic crisis. On August 15, Nixon announced to the world that the United States would suspend gold convertibility, effectively ending the Bretton-Woods system and eliminating gold’s role in monetary policy. From then on, the major countries of the world were on a fiat system, where money was backed by the faith and credit of the federal government and nothing more.
Here is the point: In a fiat system, central bank credibility is the nominal anchor.
The US had to learn this the hard way. Nixon, concerned with his reelection, pressured Arthur Burns into keeping interest rates artificially low. Throughout the 1970s, the Federal Reserve engaged in a “stop and go” policy, increasing rates but then shortly pulling back. The Fed’s inflation-fighting credibility was all but lost, and it looked like the dollar would lose its privileged status as established in the Bretton Woods agreement. Inflation raged throughout the 1970s, reaching 14% by 1980.
In 1978, President Jimmy Carter appointed industrialist G. William Miller to replace Burns as Fed Chairman. Miller proved just as incapable of fighting inflation as Burns. Luckily, Miller’s tenure was short-lived. He stepped down in the summer of 1979 to accept a nomination as Treasury Secretary. With inflation running into the double-digits, President Carter was forced to find a Fed Chair with inflation-fighting credibility. He found such a man in Paul Volker.
In many ways, Volker is the hero of our story. At a height of 6’7”, Volker was an imposing figure. Since 1975, he served as president of the Federal Reserve Bank of New York, where he had earned a reputation as being in favor of a more constrained monetary policy.
On October 6,1979, Volker convened an unscheduled meeting of the FOMC. Later that day, Volker held a press conference and announced a change in the Fed’s operating procedures. Instead of implementing monetary policy by targeting interest rates, the Fed would directly target growth in the money supply. With this change, the Fed would let interest rates fluctuate in response to monetary tightening.
To what extent Volker was committed to this policy is up for debate. Many economists have suggested that the policy change was a pretext for obtaining much higher interest rates, without having to announce higher rates as an intentional policy decision. Either way, the impact was severe. Credit contracted and interest rates spiked. The economy fell into a deep recession, with unemployment hitting nearly 11% in 1982. The Fed came under enormous scrutiny from both politicians and the public. Although President Reagan remained supportive in public, members of his administration, such as Treasury Secretary Don Regan, were more inclined to publicly criticize the Fed. Members of Congress from both political parties were also highly critical. Henry Gonzalez, a Congressman from Texas, even threatened to introduce legislation to impeach Volker and other Fed governors.
By the summer of ’82, the recession bottomed out, and the Fed began to loosen its grip on the money supply. The stock market began to rebound, and the economy started to recover. Criticism and political pressure subsided as the recovery took hold.
Modern Implications for Fed Independence
Volker stepped down from the Chairmanship in 1987, replaced by economist Alan Greenspan. Since Greenspan’s tenure onward, presidential administrations have, with little exception, withheld criticism of the Fed and its policy decisions. This era may be coming to an end. The risk is not just from the current administration. As economist Kenneth Rogoff argues in a new book, fiscal debt levels well in excess of US economic output will pressure future administrations to at least partially monetize the debt.
The Fed’s independence is not, and never has been, absolute. But independence from overt political interference remains key to continued confidence in the dollar.
Summary
Federal Reserve independence is not a political abstraction — it is a foundational element of the modern financial system. In a fiat monetary regime, credibility replaces gold as the anchor for inflation expectations. When that credibility is weakened by political pressure, the consequences are not immediate, but they are persistent: higher inflation expectations, higher interest rates, increased volatility, and lower real returns for investors.
History shows that periods when monetary policy became subordinate to political objectives — from the inflationary 1970s to earlier Treasury dominance — were followed by instability that took years, and often recessions, to correct. Once credibility is lost, restoring it requires painful adjustments that affect employment, asset prices, and economic growth.
While the Federal Reserve has never been fully independent, maintaining distance from overt political interference has been critical to preserving confidence in the dollar and the broader financial system. For investors, understanding this institutional backdrop is essential. Markets may remain calm in the short run, but long-term outcomes are shaped by credibility, expectations, and discipline — not headlines or political preferences.
Sources:
Hetzel, Robert. The Federal Reserve: A New History. University of Chicago Press, 2022.
Rogoff, Kenneth. Our Dollar, Your Problem: An Insider’s View of Seven Turbulent Decades of Global Finance, and the Road Ahead. Yale University Press, 2025.
