Trump's Fed Chair Choice Could Stoke Stagflation Risks

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At the heart of the dispute with the Federal Reserve is Trump's view that as president, he should be consulted on the setting of interest rates. With Americans facing a deepening affordability crisis, and Trump taking the blame, he is feeling the pressure to cut interest rates to boost growth.

Accordingly, Trump has insisted that the next chair of the Fed must be someone who is prepared to immediately and significantly cut interest rates, and listen to Trump's views on monetary policy going forward.

Reduced interest rates might provide short-term juice to spur spending. However, in the long-term artificially low interest rates cause inflation, only worsening any cost-of-living crisis. For this reason, most developed countries maintain strictly independent central banks.

Central bank independence ensures short-term political considerations like elections and polling numbers do not interfere with long-term planning of monetary policy.

Back to the 70s?

In 1970, during a growing inflation crisis, President Richard Nixon appointed economist Arthur Burns as chairman of the Federal Reserve. Like Trump, Nixon demanded that Burns reduce interest rates and listen to the president's advice in crafting monetary policy. At Burns' swearing in, Nixon said he would meet with Burns regularly, adding:

Under pressure from the president, who threatened to pass legislation diluting Fed independence if Burns did not comply, Burns repeatedly cut interest rates. However, prematurely low interest rates and the perception that the president was influencing monetary policy only deepened the economic crisis facing the US in the 1970s.

The result was stagflation, the dismal economic situation in which both inflation and unemployment increase simultaneously. Under Burns' watch, annual inflation peaked at 11% and unemployment at 8.5%.

A protest march in 1970s New York against surging inflation. H. Armstrong Roberts/Getty

The“Great Inflation” of the 1970s was eventually ended by another Fed chief, Paul Volcker. Recognising that Burns had created a spiral of inflationary expectations, in 1980 Volcker drastically increased interest rates to 19%. Volcker then kept interest rates in double digits until inflation permanently fell.

The so-called“Volcker shock” did eventually tame inflation, but at the cost of cripplingly high interest rates and surging unemployment.

The Great Inflation of the 1970s, and the price paid to end it, stands as a strong warning against the short-term sugar hit of reducing interest rates in response to political pressure.

Will Trump learn the lessons of history?

With some economists warning signs of stagflation are once more emerging, Trump must now pick the next chair of the Federal Reserve.

Prediction markets suggest the most likely candidate is Kevin Hassett, an economist appointed last year by Trump as director of the National Economic Council.

Like Trump, Hassett believes interest rates should be much lower. Having served in both Trump administrations, Hassett also appears likely to offer loyalty and compliance with Trump's demands.

The second candidate under consideration by Trump is economist Kevin Warsh, a former Fed governor and bank executive. Warsh brings a reputation as an inflation hawk from his time at Federal Reserve during the Global Financial Crisis.