The Federal Reserve System was established by Congress in 1913.  Prior to its establishment in 1913, the US had experienced a number of significant financial crises¹, most which were almost single handedly managed by a single private man and banker, John Pierpont Morgan (J P Morgan). There was assessed to be a need for government to put in place a permanent system for continuous monetary system oversight – financial crises, of which there had been many, could not be solved by a single man (Morgan himself died in 1913) and the United States had become the world’s largest economy around 1890. 

The idea of establishing a central monetary system was highly contentious and many argued an overreach for a government body. Some 111 years later, similar sentiments abound as to whether the Federal Reserve (the Fed) should be accountable not just to Congress (legislature) but also directly to the President (executive). If answerable to both the Congress for its mandate and to the President, the argument is how can the Fed dispassionately and in a non-partisan manner perform its independent mandate if answerable to the politics of the day? 

Whilst far from perfect, western central banks are largely independent of short-term political direction, instead focussed on medium term price stability (inflation), employment and financial system stability.  Since the early 1980’s and the inflation fighting stewardship of Fed Chairman Paul Volcker, central banks have broadly met their mandates. 

So, what is the Federal Reserve System of the United States of America? 

The Fed’s purpose is to perform five (5) key functions to serve all Americans and promote the health and stability of the US economy and financial system through: 

1. Conducting monetary policy (via the FOMC) 

2. Promoting financial system stability 

3. Supervising and regulating financial institutions 

4. Ensuring payment and settlement system safety and efficiency, and  

5. Promoting consumer protection and community development. 

Most importantly, in conducting monetary policy, the Federal Reserve has a dual mandate to: 

1. Promote maximum employment and  

2. Stable prices – this is known as the dual mandate²

Operated by a Board of Governors (with the agency located in Washington DC), there are seven Governors who are appointed by the President and affirmed by the Senate for terms of 14 years. The president appoints a Chairman from the group of Governors (currently Jerome Powell) and a Vice Chairman, again requiring confirmation from the Senate.  The Chair and Vice-Chair are appointed for terms of four (4) years but if not reappointed, are entitled to serve out their 14 year Governor appointment period.   

The Governors oversee the Federal Reserve System of 12 Federal Reserve Banks and importantly, are also members of the Federal Open Market Committee (FOMC) which oversees and sets US monetary policy. The FOMC has a further five (5) members in the President of the Federal Reserve Bank of New York and four (4) of the remaining 11 Reserve Bank Presidents who serve one-year terms on a rotating basis. The remaining 7 Reserve Bank presidents attend FOMC meetings and participate in FOMC deliberations. 

Here, we can see the twelve (12) Federal Reserve Banks of the Federal Reserve System³ - diagram 1. The twelve Presidents are appointed by the directors of each Reserve Bank with the consent of the Board of Governors.      

When it is said that the Fed is meeting this month, this refers to the Federal Open Market Committee, or FOMC. The FOMC is required to meet at least 8 times each year. It is chaired by the Chairman of the Federal Reserve.  At meetings, all members (voting and non voting) will table and  discuss information and data on the state of the economy.  Monetary stance resolutions are voted on by members for a majority.  All the time, members have a responsibility to achieve Congress’s legislated dual mandated goals of maximum employment and price stability. The contention is not the mandate, but what policy measures should be implemented to get there, stay there, and if need be, return to it. This was starkly demonstrated through COVID (between 2020-2022) with highly accommodative monetary policy (interest rates & quantitative easing) to support employment and protect against deflation, to then immediately be reversed into restrictive policy (2022 – 2024) to bring inflation back to the 2%⁴ target, having been 8% in 2022. 

Those seeking or wishing re-election as President, naturally seek the most favourable economic environment for the electorate, exercising their “hip pocket nerve”.  One of Bill Clinton’s strategists summed it up in 1992, “it’s the economy, stupid”⁵. Blame the other side for high inflation, high rates, high taxes, big government and hope you can do better if you are elected.    

The US economy is currently performing reasonably, having previously been performing very well.  This was supported by the combination of post-COVID demand for services, households in good balance sheet health (moderate debt fixed at very low COVID rates, accumulated savings), corporates in good strategic and financial health (COVID reset on top of the GFC reset), strong immigration and massive government stimulus through the Inflation Reduction Act and the Chips & Science Act.  So, with capacity constrained, higher inflationary expectations took hold.  The Fed responded, raising the Fed Funds Rate from 0.25% to 5.5%, quite independently of the Executive.  This September, the Fed eased by 0.5%, two months out from the US Election.  This is the judgement of the 12 voting FOMC members independent of government (there was one dissent for cutting rates by the larger 0.5%).   

Can the executive through the President materially impact this process and upset the equilibrium between independent monetary policy and the operation of government (taxation, spending and executive order)?  Not particularly, at least in terms of the framework and mechanisms by which the Federal Reserve and FOMC were designed to operate which are robust and enduring. It is probably most fortunate that the Fed structure was established in 1913, a time when Congress did not operate with the extreme partisan politics we see today.  The President of the day can of course make new appointments to the Board of Governors (remembering they are 14 year terms).  This is a slow ‘roll’, and requires retirements to coincide with the President of the day and the same political attitudes prevailing for a long period.  

The risks in reality are more implied (and potentially corrosive). These are: 

1. Appointment of a Chairman to the Fed board which represents the tone and voice of the Executive rather than the majority of the Governors and FOMC 

2. Criticism of the Federal Reserve institution and its independence, rather than the regular “jaw-boning” on interest rate policy settings from politicians.  In turn, this undermines the whole institution and community support for the Fed’s independent role (the short terms holding sway over longer term stability). 

These risks are real and do matter. The key aspect goes to the dual mandate and particularly price stability.  The US Government (and States & Municipalities) is a significant issuer in world debt markets, particularly given the increasing size of government and the need to fund deficits – diagram 2. Deficits are the norm in the US, but their size as a proportion of the economy has tripled over the last 30 years and this forecast is set to continue well into the next 10 years.  Indeed, markets are accustomed to loose fiscal policy. That said, markets take significant comfort from the Federal Reserve overseeing price stability to a 2% target. This creates a supportive environment for government bond markets. It is a matter of confidence when you operate through fiat currency like the USD. 

The role of monetary policy is crucial when your government is a net borrower from world capital markets, and as the world’s reserve currency, this debt is USD denominated.  For example, whilst the Biden Administration has been stimulating the economy, the Federal Reserve has acted as a counterweight through restrictive monetary policy.  Congress and Executive deal with their constituents, whereas the Federal Reserve is responsible for the aggregate total (and the dual mandate) measured over the medium to long term.   

If markets were to assess the future conduct of monetary policy as deviating from its current approach, or to be under attack, then the consequences are likely (very) adverse for USD denominated debt and the currency. Uncertainty needs to be compensated for, and this would occur through higher bond rates and a lower currency, and more severely, reduced appetite for USD assets (equities and debt). 

The current level of gross US Government Debt at 120% of GDP, compared with pre GFC levels under 60% is concerning – diagram 3.  The trajectory is potentially of greater concern, especially given partisan politics lack of will to better manage fiscal policy. The US needs the full confidence of markets now and going forward to finance its current and future needs.   

Small things can upset markets. Case in point was the Liz Truss/Kwasi Kwateng September 2022 mini budget which was poorly received by bond markets. The result was a bond market crash where 10 year UK Gilt rates moved from 2% pa to over 4% from over a three week period, and Sterling lost 9% of value (to the USD). 

When you are the world’s largest economy, the USD is the world’s reserve currency and you the world’s largest borrower, confidence in the Federal Reserve System and setting of monetary policy does matter.  Going forward, it would be sufficiently damaging if markets were given reason to lose confidence in the Federal Reserve’s ability to conduct monetary policy.