Should you be worried about Fed independence?
Concerns about the Federal Reserve's independence are rising amid expansionary fiscal policy and upcoming personnel shifts. Closer fiscal-monetary coordination may improve effectiveness, but investor concerns about inflation-fighting ability are a critical feedback loop. Markets will therefore render the ultimate judgment via the bond market.
Against the backdrop of a post-COVID revival in expansionary fiscal policy, global concerns are accelerating that central bank independence may be waning. Worries in the United States (US), especially, are intensifying due to upcoming leadership changes at the Federal Reserve Board of Governors (Fed).
But there are two important caveats that challenge the reductionist idea that central banks are simply becoming less independent.
Changes in leadership happen each election cycle
First, each electoral cycle ushers in new monetary policymakers over the course of a term. Personnel changes on their own do not equate to wholesale institutional revamp. Fed governance is designed to maintain stability, so even when new policymakers step in, continuity persists throughout many parts of the organization.
Better coordination can lead to better outcomes
Second, and more controversially, closer coordination between those who manage government spending (fiscal policy) and those who manage interest rates and money supply (monetary policy) could actually improve the overall policy mix and lead to better results.
Having experienced decision-makers who understand both sides—and don’t work at cross-purposes—can help create stronger, more aligned policies in pursuit of strategic national goals. Indeed, one of the lessons from the Eurozone crisis in the early 2010s is that a lack of fiscal-monetary policy coordination can deliver poor outcomes.
Markets, and investors, will be the ultimate judge
Some worry this isn’t about improving policy—it’s about subduing independent agencies to executive will. So, who decides whether it’s better policy coordination or political control? Simply put: the markets do.
Global investors will ultimately judge whether Fed independence is truly at risk or if institutional decision-making quality is being weakened. If market participants lose confidence in the Fed’s ability to manage inflation, that will show up in how inflation-linked assets are priced.
We still believe this would first express itself in a steeper yield curve via a wider term premium. Over the past two years, the curve steepening on the long end of the yield curve (30-year over 5-year) has paralleled an increase in the term premium. While the curve steepened sharply following last November’s election outcome, to some extent, this also reflects where we are in the monetary policy cycle: a restrictive stance that cannot be sustained through the business cycle (Figure 1).
If worries about inflation intensify, more benign bull steepener dynamics could give way to more troublesome bear steepener moves. Also, this shift would likely support the ongoing tailwind to the multi-year dollar weakening cycle that we expect to continue through the rest of the decade.
Watch the curve, not the commentary
Concerns about Fed independence—especially amid fiscal expansion and personnel changes—are understandable. But the situation isn’t black and white. Fed governance, or institutional design, and the potential benefits of policy coordination offer important counterpoints.
Ultimately, it is not political speculation that will determine if the Fed’s credibility is at risk—it’s market behavior. If investors believe inflation management is slipping, you’ll see it reflected in yield curves, term premiums, and inflation-linked asset pricing—that will determine whether the Fed’s credibility is truly at risk. The final verdict belongs to markets, not market pundits or even policymakers themselves.