Tag: inflation

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Controlling inflation with higher interest rates – a blunt instrument?


Inflation has been rising around the world. The main reason has been the supply shock of rising oil, fertiliser and commodity prices caused by the Iran war and the disruption to global supply chains from conflicts in the Middle East and Russia (see the blog, Why have diesel prices risen more than petrol prices?). Central banks, including the US Federal Reserve Bank, the European Central Bank and the Bank of Japan, have responded to this cost-push inflationary shock by raising interest rates. The Bank of England is likely to raise Bank rate at its next meeting on 5 November 2026.

Similar supply shocks have been experienced in recent years (see the May 2026 blog, Supply shocks – long-term gain from the short-term pain?).

Raising interest rates reduces aggregate demand, or at least its rate of growth. This puts downward pressure on prices, or at least on the rate of inflation. This can be illustrated in the diagram. (Click here for a PowerPoint.)

It shows a country’s initial short-run aggregate supply curve (SRAS1) and initial aggregate demand curve (AD1). The price index is P1 and real GDP is Y1.

The higher costs shift the SRAS curve upwards to the left, say to SRAS2. The price index rises to P2 and real GDP falls to Y2. If, in response to the higher prices, the central bank raises the interest rate, this shifts the aggregate demand curve to the left, say to AD2. As a result, the price index falls back to P1, but the fall in demand causes real GDP to fall further, to Y3.

Policy alternatives

So, is a rise in interest rates the appropriate response to higher costs that push inflation above, or further above, its target, which for most countries is 2%?

If the cause of inflation was excessive increases in aggregate demand from, say, large government budget deficits or a large increase in consumer demand, then a rise in interest rates would have helped reduce this unsustainable rise in demand. But if the cause of the inflation is a supply shock, is curbing aggregate demand the correct solution?

Ideally, the solution would be to tackle the cost increases directly. A rise in productivity, for example, would help to increase aggregate supply and counter the effect of rising commodity prices. But productivity increases take place over the longer term and are not a solution to a short-term supply shock. Better still, if the increase in commodity prices could be reversed, by finding a political solution that reopened the Strait of Hormuz and other choke points, then higher interest rates would not be needed.

Alternatively, some countries might be able to resort to price controls. These could be targeted at specific sectors such as energy, rent or construction. For example, the UK government has used energy price caps to limit household energy bills.

But even though this may control inflation in the short term, price controls create shortages because demand exceeds the reduced supply. This could lead to higher prices in unofficial markets as people sought to avoid the price controls. It could also create considerable problems for firms planning their logistics when supplies may simply not be available.

Alternatively, subsidies could be used to support output or prices in similar areas. Or they could be targeted at low-income households. These, however, could be costly for governments and may distort markets.

If price controls and subsidies are rejected, and in the absence of short-term increases in aggregate supply, the only solution to inflation is curbing aggregate demand to match the reduced aggregate supply. This could be achieved through fiscal policy by raising taxes or reducing government expenditure, but would prove unpopular and would probably be rejected by governments. Generally, they would prefer to pass the burden to central banks through the use of monetary policy.

The blunt instrument of monetary policy

But, raising interest rates is, indeed, a blunt instrument. Tighter monetary policy cannot increase the global supply of fuel, fix broken supply chains or lower insurance and construction costs. In other words, it cannot directly fix supply shocks, only limit their effect on prices.

Also, by making borrowing more expensive, higher interest rates may suppress business investment and house building. This adverse supply-side effect may worsen inflation over the longer term.

The hope is that such effects will be avoided by suppressing inflation and helping thereby to maintain business confidence. It is a delicate balancing act for central bankers, who want to constrain inflation but do not want to plunge their economies into recession and damage longer-term increases in potential real GDP.

Most of all, the hope is that by suppressing nominal demand, second-round effects will be avoided. These are where higher prices encourage workers to demand higher wages to compensate for higher prices and businesses to raise prices to cover those wage increases, knowing that they can pass these price increases on to consumers as their competitors are doing the same. This risks creating a damaging wage-price spiral and embedding inflation. By raising interest rates and signalling that they will bring inflation back down to the target rate, central banks hope to anchor long-term inflation expectations. They hope that this will ensure that temporary price shocks do not become permanently embedded in the economy.

Distributional consequences

However, the burden of higher interest rates will not be shouldered equally. They predominantly penalise a minority of the population, especially younger households with consumer debt and/or large variable-rate mortgages relative to their income or fixed rate mortgages coming the end of their term and requiring renewing. They also penalise businesses which rely on short-term debt.

Meanwhile, people who own their homes outright or wealthy savers may be largely unaffected or even benefit from higher yields on their savings deposits. Similarly, firms with low debt may hardly be affected.

Consequences for servicing public debt

Higher interest rates increase governments’ debt-servicing costs. More has to be paid on new borrowing, either to finance budget deficits or to replace government bonds and bills that are maturing. This consumes a larger share of public spending and limits the fiscal room to support vulnerable households suffering from the price and interest increases.

We examined such costs in the US context in the blog US national debt reaches $40 trillion: but does it matter?.

Fingers crossed!

By being cautious about raising interest rates, central banks hope that geopolitical developments will be favourable and that the supply constraints will diminish. For example, the hope is that there will be a settlement between the USA and Iran that allows oil to flow once more through the Strait of Hormuz. That is why, despite inflation being well above target, central banks have been raising interest rates by just a quarter of a percentage point.

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Questions

  1. What policies have central banks pursued during the Iran war?
  2. Paint an optimistic scenario for the global economy five years hence.
  3. Paint a pessimistic scenario for the global economy five years hence.
  4. Compare the reasons given by the Federal Reserve and ECB for raising interest rates with those given by the Bank of England for not raising them.
  5. Donald Trump argues for cutting interest rates as a stimulus to the US economy. Provide a critique of this policy.
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The global economic impacts of the war with Iran – update

With relentless bombing of Iran by Israel and the USA, and with Iranian counterattacks on Gulf states, the costs of the war are mounting. The most obvious are in terms of human lives, injuries and suffering. But there are significant economic costs too. Some of these are immediate, such as the rising price of oil and hence the costs of fuel, or the fall in stock market prices. Some will be longer term, depending on how the war develops. For example, prices could rise more generally as supply chains are disrupted.

The impacts will vary across the world and across markets. The most obvious markets to be affected are those where significant supply comes from the Persian Gulf. Approximately 20% of total global oil consumption passes through the Strait of Hormuz, which connects the Persian Gulf with the Arabian Sea and the Indian Ocean.

Oil prices rose considerably in the days following the start of the war on 28 February, with Brent crude, a key measure of international oil prices, rising from $71.3 on 27 February to a peak of $119.4 per barrel by the morning of 9 March – a rise of 67%. It was possible that they would rise even further in the short term. However, prices fell back substantially later on 9 March after G7 finance ministers declared that the group ‘stands ready’ to release oil from strategic reserves if needed. By late in the day, the price had fallen to below $85. (Click here for a PowerPoint of the chart.)

However, despite the announcement on 11 March that 32 countries had agreed to release 400m barrels of oil reserves, oil prices began rising again and reached $100 on 12 March after three tankers had been struck in the Gulf, two of them close to the Strait of Hormuz. With Iran pledging to keep the Strait closed, there were worries that the release of oil reserves would provide only temporary relief. Just over 20m barrels of oil normally pass through the Strait of Hormuz. The 400m barrels released from storage is the equivalent, therefore, of only 20 days’ worth of lost oil from the Gulf.

Not only did oil prices rise, but the price became much more volatile as markets reacted to the news on a continuous basis. Intra-day fluctuations in oil prices of several percentage points became typical, reflecting shifting expectations. The second chart shows daily fluctuations, with the highest and lowest prices for each day shown, along with the closing price. (Click here for a PowerPoint.)

The biggest fluctuation had been on 9 March when fears of the closing of the Strait of Hormuz saw the price of Brent crude rising to nearly $120 but falling to around $84 later in the day (a fall of around 30%) after the G7 announcement about releasing reserves.

There was another big fluctuation on 23 March. The previous day (Sunday), President Trump threatened to bomb Iran’s power plants if Iran did not allow free passage of ships through the Strait of Hormuz. Iran threatened to retaliate by striking Gulf countries’ energy and water systems. In early trading on Monday 23rd, Brent crude rose to over $115 per barrel. But later that day, Trump said that there had been constructive talks between the USA and Iran. The oil price immediately dropped to around $96 – a fall of 17% – before settling at around $100.

Rising oil prices will drive up inflation. For those countries with a heavy dependence on Gulf oil, particularly countries in Asia, there could be significant supply problems. For oil exporters in the Persian Gulf, with tankers unable to traverse the Strait of Hormuz, the economic impact is huge. Oil exporters outside the Gulf, such as Russia, Norway and Canada, however, will gain from the higher prices. Clearly the size of these effects will depend on how long the conflict continues and how long the Strait of Hormuz remains closed.

And it is not just oil that is affected. Other products, such as liquified natural gas (LNG), petrochemicals, industrial materials, fertilizers for food production, medicines, helium for microchip production, metals and minerals are transported through the Strait of Hormuz. Gulf countries import much of their food through the Strait. On 18 March, Israel struck Iran’s huge South Pars gas field off the Gulf coast. This is the largest gas field in the world and is a major source of export revenue for Iran. Iran responded by striking the Qatari gas hub in Ras Laffan. Donald Trump responded by threatening to ‘blow up’ the entire Iranian South Pars gas field if Iran made further strikes on Qatar. The effect of this escalation was to drive oil and gas prices up further. By the week ending 20 March, the oil price closed at just over $112 per barrel.

Cuts in supplies of oil and other products represent an adverse supply shock. Such shocks push up prices (cost-push inflation), while adversely affecting aggregate output. This can lead to stagflation – a combination of higher inflation and stagnation or even falling output. Central banks with a simple mandate to keep inflation to a target are likely to raise interest rates, or at least delay in reducing them. In the USA, with a dual mandate of controlling inflation but also maximising employment, the response may be less deflationary, depending on the judgement of the Federal Reserve.

Uncertainty

There is great uncertainty about how long the conflict will last. There is also a lack of clarity and consistency from the US administration about its war aims. This uncertainty has affected financial markets, which have seen considerable volatility. Stock markets have seen widespread falls, with airline, travel and AI-heavy stocks being particularly vulnerable.

If the war is concluded relatively swiftly, the economic effects could be relatively small. If the war continues, and especially if the Gulf countries are drawn further into the conflict and if the conflict spreads to other countries, the economic effects could be much more substantial. A prolonged conflict could see oil prices remaining above $100 per barrel, potentially increasing global inflation by 1 percentage point or more. This would slow or halt the move by central banks to cut rates and thereby reduce global economic growth – potentially, as we have seen, leading to stagflation.

The uncertainty was reflected in the decision of the Fed to keep interest rates unchanged at its meeting on 17/18 March. The Fed has the twin targets of keeping inflation close to 2% and maximising employment. Fed Chair, Jay Powell, acknowledged the current tension between the two goals: ‘upward risks for inflation and downward risks for employment, and that puts us in a difficult situation’. He also recognised that the future for inflation and the economy was highly uncertain as the war developed. This made interest rate setting difficult.

Then there is the issue of a potential new international refugee crisis. If the economic and political system in Iran deteriorates rapidly, this could trigger a wave of migration to neighbouring countries, such as Turkey, already hosting large numbers of refugees. Many could seek sanctuary further afield in Europe, with several countries already facing a backlash against immigration. The political and economic effects of this on host countries could be significant – but as yet, highly uncertain.

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Questions

  1. Who are the biggest gainers and losers from disruption to oil supplies from the Persian Gulf?
  2. Illustrate the effect of the current oil price shock on an aggregate demand and supply diagram (either static or dynamic).
  3. Why is the Iranian war likely to be less damaging to the European economy than the Ukrainian war has been?
  4. Why have AI-related stock prices been vulnerable to the uncertainty caused by the Iranian war?
  5. How have the Bank of England and the Federal Reserve Bank responded to higher oil prices and the broader economic effects of the war? Why might their responses be different in the coming months?
  6. What is the likely impact of the Iranian war on global economic recovery?
  7. How might the Iranian war affect global economic alliances?
  8. How is the current oil price shock likely to affect the eurozone? Will it be different from the oil price shock that followed the Russian invasion of Ukraine?
  9. What are the likely economic effects of large-scale migration caused by the war?
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The Russian economy after four years of war

At the fourth anniversary of Russia’s invasion of Ukraine, we look at the effect of the war on the Russian economy. Two years ago, in the blog The Russian economy after two years of war, we argued that the Russian economy had seemingly weathered the war successfully.

Unlike Ukraine, very little of its infrastructure had been destroyed; it had started the war with a current account balance of payments surplus, a budget surplus and a low general government debt-to-GDP ratio; it had achieved a lot of success in diverting its exports, including oil, away from countries imposing sanctions to countries such as China and India; it was the same with imports, with China especially becoming a major suppliers of machinery, components and vehicles; it has a strong central bank, which engenders a high level of confidence in managing inflation; the military expenditure provided a Keynesian boost to the economy, with production and employment rising.

The situation today

But two years further on, the Russian economy is looking a lot weaker and on the verge of recession. GDP growth fell to 0.6 per cent in 2025 and is forecast to be no more than 1 per cent for the next two years. (Click here for a PowerPoint of the chart.) And despite growth still being positive (just), this is largely because of the growth in military expenditure. Retail and wholesale trade fell by 1.1% in 2025, reflecting supply chain problems and high inflation dampening consumer demand.

With labour being diverted into the armaments and allied industries or into the armed forces, this has led to labour shortages. This has been compounded by the emigration of up to 1 million people by 2025 – often young, educated and skilled professionals.

Official CPI inflation averaged 8.7 per cent in 2025, although the prices of food and other consumer essentials rose by more, especially in recent months. At the beginning of 2026, supermarket prices rose by 2.3% in just one month, made worse by a rise in VAT from 20% to 22%. The central bank has responded to the high inflation with high interest rates, which averaged 19.2% in 2025, giving a real rate of 10.5%. With such a high real rate, the response of households has been to save. This has masked the constraints on production, or imports, of consumer goods. Savings have also been boosted by large payments to soldiers and bereaved families, with the money saved by the recipients being used in part to fund future such payments. So far there has been trust in the banking system, but if that trust waned and people starting making large withdrawals of savings, it could be seriously destabilising.

Whilst the high real interest rates have helped to mask shortages of consumer goods, they have had a seriously dampening effect on investment by domestic companies. Gross capital formation fell by 3% in 2025, not helped by an increase in the corporation tax from 20% to 25%. At the same time, foreign direct investment remains subdued due to high perceived risks. The lack of investment, plus the labour shortages, will have profound effects on the supply side of the economy, with potential output in the non-military sector likely to decline over the medium term.

The balance of payments and government finances are turning less favourable. The balance of trade surplus has declined from US$173bn in 2021 to US$67bn in 2025. This could decline further, or even become a deficit, if oil prices continue to be weak, if Western sanctions are tightened (such as stopping the flow of Russian oil exports in the ‘shadow’ fleet of tankers) or if major importing countries stop buying Russian oil. Indian refiners have announced that they are not taking Russian crude in March/April as India seeks to finalise a trade deal with the USA.

The budget balance has moved from a small surplus of 0.8% of GDP in 2021 to a deficit of 2.9% in 2025. Although the government debt-to-GDP ratio remains low by international standards at 23.1% of GDP in 2025, this was up from 16.5% in 2021 and is set to rise further as budget deficits deepen. Nevertheless, as long as the saving rate remains high, the debt can be serviced by domestic bond purchase.

Russia’s economy is definitely weakening and labour shortages and low investment will create major problems for the future. But whether this deterioration will be enough to change Russia’s stance on the war in Ukraine remains to be seen.

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  1. What constraints are there currently on the supply side of the Russian economy?
  2. Some economists have argued that the economic effects of a stalemate in the Ukraine war would suit the Russian leadership more than peace or victory. Why might this be so?
  3. Under what circumstances might a deep recession in Russia be more likely than stagnation?
  4. In what ways does Russia’s current financial system resemble a pyramid scheme?
  5. What cannot a Keynesian boost contunue to support the Russian economy indefinitely?
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Shrinkflation, skimpflation and sneakflation: ways of hiding inflation

Have you noticed that many products in the supermarket seem to be getting smaller or are poorer quality, or that special offers are not as special as they used to be? When you ring customer services, does it seem that you have to wait longer than you used to? Do you now have to pay for extras that used to be free? These are all ways that producers try to pass on cost increases to consumers without rising prices. There are three broad ways in which producers try to hide inflation.

The first is called ‘shrinkflation’. It is defined as having less product in the same package or a smaller package for the same price. For example, reducing the number of chocolates in a tub, reducing the size of a can of beans, jar of coffee or block of butter, reducing the number of sheets in a toilet roll, or the length of a ride in a fairground or portion sizes in a restaurant or takeaway. A 2023 YouGov poll revealed that 75% of UK adults are either ‘very’ or ‘fairly’ concerned about shrinkflation. A similar poll in 2025 showed that this figure had increased to 80%. The product category with the greatest concerns was snack foods (e.g. crisps, confectionery items, nuts, etc.).1

The second form of hidden inflation is called ‘skimpflation’. This is defined as decreasing the quality of a product or service without lowering the price. Examples include cheaper ingredients in food or confectionery, such as using palm oil instead of butter, or reducing the cocoa content in chocolate or the meat content in sausages and pies, or package holidays reducing the quality of meals, or customer service centres or shops reducing the number of staff so that people have to wait longer on the phone or to be served.

The third is called ‘sneakflation’. This is similar to skimpflation but normally refers to reducing what you get when you pay for a service, such as a flight, by now charging for extras, such as luggage or food. Sometimes shrinkflation or skimpflation are seen as subsets of sneakflation.

These practices have had a lot of publicity in recent months, with consumers complaining that they are getting less for their money. Many people see them as a sneaky way of passing on cost increases without raising the price. But the changes are often subtle and difficult for shoppers to spot when they are buying an item. Skimpflation especially is difficult to observe at the time of purchase. It’s only when people consume the product that they think that it doesn’t seem as good as it used to be. Even shrinkflation can be hard to spot if the package size remains the same but there is less in it, such as fewer biscuits in a tin or fewer crisps in a packet. People would have to check the weight or volume, while also knowing what it used to be.

If firms are legitimately passing on costs and are up-front about what they are doing, then most consumers would probably understand it even if they did not like it. It’s when firms do it sneakily that many consumers get upset. Also, firms may do it to increase profit margins – in other words, by reducing the size or quality beyond what is necessary to cover the cost increase.

Does the official rate of inflation take such practices into account?

The answer is that some of the practices are taken into account – especially shrinkflation. The Office for National Statistics (ONS) accounts for shrinkflation by monitoring price changes per unit of weight or volume, rather than just the price. Data collectors track the weight, volume or count of item. When a product’s size is reduced, the ONS records this as a price increase in CPI or CPIH inflation statistics. This is known as a ‘quality adjustment’ process and allows the ONS to isolate price changes from product size changes. As CPI data from the ONS is used by the Bank of England in monitoring its 2% inflation target, it too is incorporating shrinkflation.

ONS quality adjustments are also applied to non-market public services, such as healthcare, education and policing to measure changes in service quality rather than just volume. This allows a more accurate measurement of productivity as it focuses on outcomes and user experience per pound spent rather than just focusing on costs.

Skimpflation is more difficult to monitor. The quality adjustment process may miss some quality changes and hence some skimpflation goes unrecorded. This means that the headline inflation rate might understate the true decline in purchasing power felt by consumers.

How extensive is hidden inflation?

Despite public perception, shrinkflation has a relatively small impact on the headline CPI and CPIH inflation rate in the UK because it is largely confined to certain sectors, such as bread and cereals, personal care products, meat products, and sugar, jams, syrups, chocolate & confectionery. Nevertheless, in these sectors it is particularly prevalent, especially in the packaged foodstuffs and confectionery sector. The latest research by the ONS in 2019 covered the period June 2015 to June 2017 and is shown in the following figure.2

According to research in the USA by Capital One Shopping, some major brands reduced product sizes by over 30% in 2025 without reducing prices, with shrinkflation averaging 14.8% among selected national grocery brands.3 Shrinkflation had been observed by 74% of Americans at their grocery store. Of these, 81% took some kind of action as a result, with 48% abandoning a brand. Nevertheless, across all products, shrinkflation accounts for quite a small percentage of any overall price rises.

A US Government Accountability Office (GAO) report found that shrinkflation accounted for less than 1/10 of a percentage point of the 34.5% increase in overall consumer prices from 2019 to 2024.4 The reason is that the items that were downsized comprised a small percentage of goods and services. Indeed, many goods and services, such as housing, cannot be downsized in the same way that household products can.

Nevertheless, with consumer budgets being squeezed by the inflation that followed the pandemic and the Russian invasion of Ukraine, hidden inflation has become more prevalent in many countries and an increasing concern of consumers.

References

  1. Shrinkflation concern rises in 2025, but fewer Britons are changing shopping habits

    2. YouGov (15/8/25)

  2. Shrinkflation: How many of our products are getting smaller?

    3. Office for National Statistics (21/1/19)

  3. Shrinkflation Statistics

    4. Capital One Shopping (30/12/25)

  4. What is “Shrinkflation,” And How Has It Affected Grocery Store Items Recently?

    5. U.S. Government Accountability Office (12/8/25)

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Questions

  1. If shrinkflation, when included in CPI statistics, accounts for such a small percentage of inflation, why are people so concerned about it?
  2. From a company’s perspective, is it a good idea to engage in (a) shrinkflation; (b) skimpflation?
  3. Go round you local supermarket and identify examples of shrinkflation and skimpflation.
  4. How are various EU countries attempting to inform consumers of shrinkflation?
  5. Why is skimpflation often harder to detect than shrinkflation?
  6. Give some other examples of sneakflation in the provision of services.
  7. How could behavioural economists help firms decide whether or how to engage in shrinkflation or skimpflation?
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Fed independence under attack

Donald Trump is keen to lower US interest rates substantially and rapidly in order to provide a boost to the US economy. He is also keen to reduce the cost of living for US citizens and sees lower interest rates as a means of reducing the burden of debt servicing for both consumers and firms alike.

But interest rates are set by the US central bank, the Federal Reserve (the ‘Fed’), which is formally independent from government. This independence is seen as important for providing stability to the US economy and removing monetary policy from short-term political pressures to cut interest rates. Succumbing to political pressures would be likely to create uncertainty and damage long-term stability and growth.

Yet President Trump is pushing the Fed to lower interest rates rapidly and despite three cuts in a row of 0.25 percentage points in the last part of 2025 (see chart below), he thinks this as too little and is annoyed by suggestions that the Fed is unlikely to lower rates again for a while. He has put great pressure on Jerome Powell, the Fed Chair, to go further and faster and has threatened to replace him before his term expires in May this year. He has also made clear that he is likely to appoint someone more willing to cutting rates.

The Federal Reserve headquarters in Washington is currently being renovated. The nine-year project is costing $2.5 billion and is due to be completed next year. President Trump has declared that the project’s costs are excessive and unnecessary.

On 11 January, Federal prosecutors confirmed that they were opening a criminal investigation into Powell, accusing him of lying to Congress in his June 2025 testimony regarding the scope and costs of the renovations.

Powell responded by posting a video in which he claimed that the real reason that he was being threatened with criminal charges was not because of the renovations but because the Fed had ignored President Trump’s pressure and had set interest rates:

based on our best assessment of what will serve the public, rather than following the preferences of the President. This is about whether the Fed will be able to continue to set interest rates based on evidence and economic conditions – or whether, instead, monetary policy will be directed by political pressure or intimidation.

The Fed’s mandate

The Federal Reserve Board decides on monetary policy and then the Federal Open Market Committee (FOMC) decides how to carry it out. It decides on interest rates and asset sales or purchases. The FOMC meets eight times a year.

The Fed is independent of both the President and Congress, and its Chair is generally regarded as having great power in determining the country’s economic policy.

Since 1977, the Fed’s statutory mandate has been to promote the goals of stable prices and maximum employment. Because of the reference to both prices and employment, the mandate is commonly referred to as a ‘dual mandate’. Its inflation target is 2 per cent over the long run with ‘well anchored’ inflationary expectations.

The dual mandate is unlike that of the Bank of England, the European Central Bank, the Bank of Japan and most other central banks, which all have a single key mandate of achieving a target of a 2 per cent annual rate of consumer price inflation over a particular time period.

With a dual mandate, the two objectives may well conflict from time to time. Moreover, changes in monetary policy affect these objectives with a lag and potentially over different time horizons. Hence, an assessment may have to be made of which is the most pressing problem. This does give some leeway in setting interest rates somewhat lower than if there were a single inflation-rate target. Nevertheless, the assessment is in terms of how best to achieve the mandate and not to meet current political goals.

Statement by former Fed Chairs and Governors

On 12 January, three former Chairs of the Federal Reserve (Janet Yellen, Ben Bernanke and Alan Greenspan), four former Treasury Secretaries (Timothy Geithner, Jacob Lew, Henry Paulson and Robert Rubin) and seven other top former economic officials issued the following statement (see Substack link in the Articles section below):

The Federal Reserve’s independence and the public’s perception of that independence are critical for economic performance, including achieving the goals Congress has set for the Federal Reserve of stable prices, maximum employment, and moderate long-term interest rates. The reported criminal inquiry into Federal Reserve Chair Jay Powell is an unprecedented attempt to use prosecutorial attacks to undermine that independence. This is how monetary policy is made in emerging markets with weak institutions, with highly negative consequences for inflation and the functioning of their economies more broadly. It has no place in the United States whose greatest strength is the rule of law, which is at the foundation of our economic success.

Response of investors

What will happen to the dollar, US bond prices, share prices and US inflation, and what will happen to investment, depends on how people respond to the threat to the Fed’s independence. Initially, there was little response from markets, with investors probably concluding that President Trump is unlikely to be able to sway FOMC members. What is more, several Republican lawmakers have begun criticising the Trump administration’s criminal investigation, making it harder for the President to influence Fed decisions.

Even if Powell is replaced, either in the short term or in May, by a chair keen to pursue the Trump agenda, that chair will still be just one of twelve voting members of the FOMC.

Seven are appointed by the President, but serve for staggered 14-year terms. Four have been appointed by President Trump, but the other three were appointed by President Biden, although one – Lisa Cook – is being indicted by the Supreme Court for mortgage fraud, with the hearing scheduled for January 21. She claims that this is a trumped-up charge to provide grounds for removing her from the Fed. If she is removed, President Trump could appoint a replacement minded to cut rates.

The other five members include the President of the New York Fed and four of the eleven other regional Fed Presidents serving in rotation. These four are generally hawkish and would oppose early rate cuts.

Thus it is unlikely that President Trump will succeed in pushing the Fed to lower interest rates earlier than they would have done. For that reason, markets have remained relatively sanguine.

Nevertheless, Donald Trump’s actions could well cause investors to become more worried. Will he try to find other ways to undermine the Fed? Will his actions over Venezuela, Cuba, Greenland and Iran, let alone his policies towards Ukraine and Russia and towards Israel and Gaza, heighten global uncertainty? Will his actions towards Venezuela and his desire to take over Greenland embolden China to attempt to annex Taiwan, and Russia to continue to resist plans to end the war in Ukraine or to make stronger demands?

Such developments could cause investor confidence to wane and for stock markets to fall. Time will tell. I think we need a crystal ball!

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Questions

  1. What are the arguments for central bank independence?
  2. What are the arguments for control of monetary policy by the central government?
  3. Assess the above arguments.
  4. Find out what has happened to interest rates, the US stock market and the dollar since this blog was written.
  5. How do the fiscal decisions by government affect monetary policy?
  6. Compare the benefits of the dual mandate system of the Fed with those of the single mandate of the Bank of England and ECB.