The Global Risks That Come With the Loss of an Independent Fed

President Trump’s threat to attempt to fire Federal Reserve Chair Jerome Powell has raised a pressing but potentially unanswerable question: What would the global economy and financial markets look like without an independent U.S. central bank?

Shielded from White House interference, the independent Fed has increasingly served as an anchor for U.S. and global markets, stepping in to steady the ship during the 2008-09 financial crisis, the Covid pandemic and other shocks of recent years. Economists credit the central bank’s ability to help keep things stable in large part to its power to make moves it deems necessary, regardless of politics.

---

---

Now, former Fed officials and investors warn that a central bank more beholden to the White House could lose its ability to act quickly and credibly in the face of financial threats. On Tuesday, Trump suggested in a White House meeting with Republican lawmakers that he could soon try to oust Powell, escalating months’ worth of criticism that the central bank has kept interest rates too high for too long. The president later said it was highly unlikely that he would fire Powell.

“Politicians almost always think interest rates should be lower than they are,” said Alan Blinder, a Princeton University economist and former Fed vice chair. “This is the major reason we need an independent central bank.”

The possibility that the firewall could crumble holds the potential to reverberate across markets at an unpredictable moment for the economy. The U.S. is still shaking off years of inflation above the Fed’s longstanding 2% target, with recent data showing that price pressures from Trump’s trade wars are beginning to mount. Central bankers and investors the world over are waiting on the Fed’s next move.

Economists fear that an unprecedented shake-up at the center of it all could add to the uncertainty—and undermine the Fed’s credibility when the next crisis explodes. That could matter not just for the U.S. economy, but other countries’ economies, too. When markets around the world have spiraled lower in the past, such as during the 1998 Russian debt crisis, the Fed has stepped in to shore them up.

The Fed’s ability to do so relies in part on its capacity to keep credit flowing when markets are freezing up, according to Harvard University economist Jeremy Stein. That requires that thousands of Fed employees are able to quickly step into the breach. He worries that threats to the Fed’s independence will over time erode the talent and depth of experience of the Fed staff.

“That—and of course the quality of leadership—can potentially make a huge difference in a crisis,” said Stein, a governor at the central bank from 2012 to 2014. 

The Fed has frequently participated in international financial rescues, such as of Mexico in 1982 and again in 1995, often to prevent a chain reaction of panic from destabilizing the global financial system. It maintains “swap” lines under which it lends dollars to foreign central banks who then lend the dollars to their own banks when they are under stress. The Fed worked with global central banks and finance ministers in the financial crisis to stop big financial firms from failing.

The Fed typically worked with the administration of the day on these rescues. It is unclear if a Fed more directly controlled by Trump would participate as readily in such efforts, or attach different conditions related to Trump’s other priorities.

The tension flaring now during a period of relative calm revolves around the core of Trump’s agenda—tariffs—and the extent to which they could spur knock-on inflation in earnest.

Trump’s pressure campaign for rate cuts has played out in public in recent months, with the president at times mocking Powell as “Mr. Too Late.” After federal data Tuesday suggested inflation accelerated modestly in June—due in part to tariff impacts—Trump said the central bank should slash its roughly 4.3% federal-funds rate by 3 percentage points.

“You say that to any economist, and they don’t know whether to laugh or cry,” said Blinder, who served at the central bank from 1994 to 1996.

Low interest rates encourage businesses and consumers to borrow and invest more, which can boost economic growth. They also risk pushing inflation substantially higher. “If you’re unwilling to raise interest rates to fight inflation, inflation is going to win,” Blinder said. 

Low rates can also inflate financial markets. Investors, unable to generate strong returns in safe assets, such as short-term Treasury notes, will move into progressively higher-risk assets, where returns are higher, but so is the danger of steep losses.

One criticism of the Fed following the 2008-09 financial crisis was that it wasn’t mindful enough of how dangerous the bubble in housing prices and mortgage-related assets had become. Not everybody agrees that the Fed was too complacent back then, but a politicized Fed might be more apt to look the other way as financial excess built up.

Another worry is that when the Fed does step in to help markets, it only emboldens investors to take even more risk later, on the assumption the central bank will bail them out if trouble hits.

While low rates can fuel an asset bubble, they can also make it more difficult for the Fed to right the economy after a bubble bursts, notes Robert Barbera, director of the Center for Financial Economics at Johns Hopkins University. That is because with rates already low, the central bank would have less scope for cutting them further.

“The room to deliver largesse will greatly shrink if you’re in the largesse-provision business all of the time,” he said.

The Fed sets a short-term lending rate called the federal-funds rate. Trump has argued that the Fed should lower rates because it could help reduce interest payments on the U.S. government’s massive pile of debt. 

But the short-term borrowing costs controlled by the Fed don’t necessarily dictate rates for longer-term loans, like mortgages, offered by commercial banks. Those rates reflect where investors believe the Fed will be setting rates well into the future. They could go substantially higher if they think today’s Fed is being pressured into causing tomorrow’s inflation problem. 

While the Fed has cut its borrowing rate by about 1 percentage point over the past year, the average U.S. mortgage rate has held roughly steady, according to Freddie Mac.  

“If you’re forcing the central bank to cut short-term interest rates, and it’s pretty clear to markets that’s the case, then it may well be that long-term interest rates go up in the opposite direction, and in a big way,” said Raghuram Rajan, an economist at the University of Chicago Booth School of Business who was governor of the Reserve Bank of India from 2013 to 2016.

This dynamic played out Wednesday immediately after reports of Trump’s threat, with investors selling off long-dated Treasurys. The U.S. dollar and stock market weakened, while the price of gold—seen as a safe haven in times of financial stress—rallied.

Those moves moderated after Trump denied planning to fire Powell. “I don’t rule out anything,” he told reporters at the White House. “But I think it’s highly unlikely.” 

Still, investors fear that volatility could be a preview of markets’ reaction if Trump ends up following through on his threat. Goldman Sachs Chief Executive David Solomon said Wednesday that Fed independence is “something we should fight to preserve.”

“I think central bank independence, not just here in the United States but around the world, has served us incredibly well,” he told CNBC. Other bank CEOs echoed the sentiment.

Some Fed skeptics question how independent the central bank actually is anyway, since it works alongside the White House in times of crisis. Others question that independence because it may constrain a president’s agenda to increase spending, cut taxes or impose tariffs.

Oren Cass, founder of the right-leaning think tank American Compass, argued that keeping rates elevated would subvert Trump’s attempt to boost manufacturing, even if tariffs buoy some prices. 

Writing on Substack this week, Cass called the Fed’s approach “a nakedly political decision intended to frustrate legitimate economic policy.”

Write to David Uberti at david.uberti@wsj.com and Justin Lahart at Justin.Lahart@wsj.com