The Risks of Politicizing Central Banks: Lessons from Hungary and Turkey

The Trump administration is attempting to pressure Federal Reserve Chairman Jerome Powell to lower interest rates. However, Rebecca Patterson, an economist and senior fellow at the Council on Foreign Relations, warns that this pressure carries significant risks and could backfire. For months, Trump has called for looser monetary policy, even demanding Powell's resignation. In a dangerous development, the White House appears to be seeking a legal justification to remove Powell, citing alleged cost overruns in the Fed's building renovations.

The Impact of Politicizing Central Banks on Economic Stability

Patterson argues that making the central bank a political tool carries obvious risks, as evidenced by reviewing the experiences of other countries. Even if the US economy and financial markets are resilient enough to absorb the shock of a damaged Fed reputation, higher long-term borrowing costs for households and businesses, and a weaker dollar leading to higher inflation, are predictable consequences.

Examples from Hungary and Turkey

Patterson examines the experiences of Hungary and Turkey as examples of the risks associated with government interference in central bank operations. In both countries, leaders facing budget deficits, inflationary pressures, and the desire to stimulate growth sought to influence monetary policy and amend laws to serve the government's political goals. This often led to artificially low interest rates to accelerate economic growth. In Hungary, the government has repeatedly attempted to influence monetary policy decisions, including by increasing the number of members on the Monetary Policy Committee. After amending laws in 2011 to undermine the central bank's independence, three credit rating agencies downgraded Hungary's sovereign debt rating to non-investment grade, leading to higher borrowing costs and a depreciation of the local currency, the forint. In Turkey, the politicization of the central bank has been even more pronounced, with more severe consequences for financial markets. In 2018, President Recep Tayyip Erdogan issued a decree granting himself the power to appoint the central bank governor, deputy governors, and members of the Monetary Policy Committee, and abolishing experience requirements. This led to downgrades of Turkey's sovereign credit rating by Standard & Poor's and Moody's.

Why Might the Trump Administration Pursue This Approach?

Patterson suggests that one potential reason is Trump's desire to lower the costs of financing the growing national debt. There may also be a desire to boost exports by weakening the dollar, as well as to support housing and equity markets. However, Patterson warns that replacing the Fed chair does not guarantee lower interest rates. Any new nominee would need to be approved by the Senate, and removing Powell could lead to a legal battle. Furthermore, a majority of the members of the Federal Open Market Committee would need to agree to any change in interest rates.

Conclusion

Patterson emphasizes that the only guaranteed way to achieve Trump's goal of lower interest rates is by reducing inflation or weakening the labor market. Even if the Fed does lower interest rates, there is no guarantee that US Treasury yields will decline. The experiences of Hungary and Turkey show that after short-term interest rates fall, long-term bond yields rise, partly due to investors demanding higher returns to compensate for inflation and political risks. Central bank independence is crucial for attracting global investment and maintaining the United States' position as a reliable investment destination. If the United States loses this stability and predictability, it risks losing its economic and financial advantages.