Trump may have done lasting damage to the Fed

US President Donald Trump’s Christmas Eve tweet that he was all alone reiterated that he considers Federal Reserve Chairman Jerome Powell a thorn in his side, one I think Trump believes he needs to pull even if Treasury Secretary Steven Mnuchin claims otherwise. We need to start thinking about what happens if Trump tries to fire Powell. Short version: It would likely be an absolute mess.

The legal framework for firing a Fed chair remains subject to debate. Fed scholar Peter Conti-Brown argues that the President could try to demote Powell from Fed Chairman back to a governor, but that would potentially still leave Powell as Chairman of the interest-rate setting Federal Reserve Open Market Committee. How the Fed might react to such a situation is unclear.

From my perspective, the best-case scenario for market participants is this: Powell steps down as chair and governor and is replaced by Fed Vice Chairman Richard Clarida. Equities tumble – maybe even go into free fall – while Treasuries surge. Clarida and his remaining Fed colleagues react by slashing rates at the January 2019 FOMC meeting, and maybe even sooner in an emergency meeting. The markets rebound, and the transition happens quickly enough that Main Street remains untouched by the gyrations on Wall Street.

The worst-case scenario is that the Fed digs in its heels and chooses to challenge Powell’s firing in the courts as a way to preserve the independence of the central bank. That process could drag on indefinitely, creating a sustained “risk off” scenario in financial markets that would eventually create sufficient damage to the broader economy that hurts Main Street.

Even in the best-case scenario, the Fed becomes another damaged institution. Arguably, it already is. There is a risk that at this point any action taken by the Fed to cushion markets or the economy will look as if policy makers are simply yielding to Trump’s demands. In other words, the appearance of independence may disappear if Trump’s antics create the uncertainty that necessitates a Fed response.

Hence, regardless of what happens, we are now well into uncharted and dangerous territory. It is not obvious that the government has the capacity to respond effectively to a financial crisis. That means that the Fed would have to shoulder an even greater role than in the last crisis. But now, the Fed may be less effective because of the damage inflicted by Trump.

Indeed, Trump appears to be both setting in motion a crisis while undermining the institution that responds to that crisis. Don’t underestimate how tense the situation has become. The risk that this downturn in stocks and other risk assets bear turns into something worse rises with each angry Trump tweet.

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