Central bank independence abused & lost? The Fed is now in trouble? Other central banks alerted.

 

Article's purpose and background

This short article sheds some lights how the present management of the Fed (the US central bank) has failed in the maintenance of so-called its independence, given its highly theoretical and arbitrary approach of the monetary policy framework. This failure has been revealed by the current conflict between the Fed and the President Donald Trump which questions the reality of the central bank independence.

The central bank independence is nothing but a hypothesis built by monetary economists who fail to understand that central banks and underlying monetary systems have been built and operate on money created on fiscal operations and debt. Therefore, the background of the article is summarized as follows.

• The origin of the present paper currency-based monetary systems operating in the world is the private bank notes and lending business. However, in early 20th century, governments nationalized such monetary systems with the creation of fiat currency and state central banks.

• Therefore, the present fiat currency-based state central banking together with underlying monetary system is a powerful instrument invented to fortify the hands of the political governments over the public and foreigners. Accordingly, the state or fiat currency along with the central bank licensed to print/create and control the currency have given the immense political power to the governments primarily in two areas. 
• First, the freedom to manage its budget or spending on the currency created by its own arm. 
• Second, the wide discretion to intervene in activities of the public through the creation and distribution of the currency and money in general.

• Therefore, the concept of the central bank independence from the government to control the creation of the currency and its use in the macroeconomic interest is a utterly false promise as it is the government that really creates and controls the country's currency whereas the central bank is only the fiscal agent to undertake the clerical job on the currency operations within the conditions permitted by the government.

The Fed's monetary policy objectives and goals

The Fed's objective is the maintenance of long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of

• maximum employment,

• stable prices, and 

• moderate long-term interest rates

The Board of Governors and Federal Open Market Operations Committee (FOMC) are responsible for policy actions as permitted by the Federal Reserve Act.

However, the Fed uses 2% inflation measured from the price index involved in personal consumption expenditure as the goal of the monetary policy with policy interest rate, i.e., federal funds rate target, as the key policy instrument. The FOMC makes decisions on the policy interest rate and relevant open market operations policy to ensure that overnight inter-bank interest rates follow the policy interest rate.

Therefore, the present model of the Fed's monetary policy is subject to several concerns.

• First, the general public is misguided on the public mandate of the Fed as it only targets inflation as the goal. The Fed does not talk about long run growth of monetary and credit aggregates or the economy's long run potential to the production growth or the supply side of the economy.

• Second, the key policy instrument is in conflict with the policy objective of moderate long-term interest rates as the Fed uses interest rate as the key policy instrument.

Present Fed policy conflict with the government

The policy conflict has arisen due to the Fed's policy tendency to keep its interest rate at the present level of 4.25%-4.50% until the impact of the proposed new tariff policy on the inflation is clear and known. The root of the conflict is due to the government view that the present level of interest rates is about 3 points higher than desirable levels in the current context (Watch media comments here).

The President Trump has announced a policy for domestic economy protected through the historic tariff-based foreign trade policy announced on 2nd April, 2025. Immediately after taking oath as the President on 20th January, 2025, the president requested the Fed to cut the interest rate sizably at the policy meeting scheduled on 19 March 2025. Further, despite the repeated requests, the Fed has continued to keep its interest rate unchanged even at the next meeting held 18 June 2025 by citing concerns over the inflationary impact of the proposed new tariff policy. Meantime, the Fed also has ruled out the possibility of a rate cut at the next meeting due on 30th this month.

The policy conflict has now elevated to the level where the President has demanded the Fed Chairman to resign immediately. Initially, the President sought to sack the Fed Chairman through an executive order, but changed the stance as the term of the present Fed Chairman is to end soon in May 2026.

A fall of inflation from 3% in January 2025 to 2.4% in May 2025 and a rise in unemployment from 3.7% in January 2024 to 4.2% in March/April 2025 are given as the basis for an immediate interest rate cut. The President seeks a sizable interest rate cut to around 1% to 2% to support his domestic economic protection policy.

The President's allegations against the Fed over the prevailing high interest rate policy are primarily of two-fold.

• First, the Fed cutting interest rates three times in total of 1% (0.75 in September, 0.25 in November and 0.25 in December) unexpectedly during the Presidential election campaign notwithstanding inflation in the range of 2.5% to 2.9% exceeding the target of 2%, which gave undue political benefits to the existing administration on easing of inflation and monetary policy as a major macroeconomic success. That was in fact stated at the election campaign.

• Second, a high interest cost around US$ 930 bn on the rollover of national debt around US$ 9 trillion this year attributable to the Fed's continued high interest rates. The President publicly blames the Fed for this excessive federal interest cost.

When compared with repeated interest rate cuts by all major central banks in anticipation of unfavorable effects of US tariffs on growth and employment in respective countries, the Fed policy stance is considered arbitrary and uncooperative with the state's economic policy.

In addition, allegations are also leveled against an undue waste of money around US$ 2 billion on renovation of the Fed building in view of the government's new national policy of anti-corruption and wasteful expenses. This will be used as the political pressure against the present Fed's management to intervene in the Fed.

Concerns over the present model of the monetary policy

The biannual testimony of the Fed Chairman was held before the House Financial Services Committee on 24th June 2025 and before the Senate Banking Committee on 25th June 2025. As usual, questions raised by Committee Members show the conceptual, bureaucratic and tunnel approach of the Fed in the conduct of the monetary policy. Unlike at Parliamentary Committees in Sri Lanka, each member is allotted 5 minutes for questioning. Therefore, a systematic and wide examination is conducted. 

Some of major concerns over the Fed's monetary policy revealed at the two Committees are listed below. Testimonies are linked here for information House  Senate. 

• The long delay in interest rate cut

The response by the Fed Chair was the need to wait until the impact of the new US tariff policy on inflation is clearly known. The Fed Chair commented that the economy was strong to wait so. If not for new tariff uncertainties, several rate cuts could have been possible by now. However, the Fed Chair also stated that tariff inflation was not observed so far and it would take about three more months to gauge the impact.

The Fed Chair also commented that the tariff is one time price shock that does not require policy changes. If so, the Fed should have followed the rate cutting cycle as usual. However, tariffs also will have passed-through or lagged effects on inflation through the labour market and global supply chains which will require policy interventions.

• Fiscal impact including the One Big Beautiful Bill (pending) on inflation

As usual, the Fed Chair responded that the Fed does not comment or speculate on government policies. Instead, the Fed assesses their outcomes on its goals based on incoming data and take decisions on meeting by meeting. This is an evading response.

• Sectoral issues in the economy and market

The response as usual was that the Fed only looks at macroeconomic performance at its goals of the price stability and employment and does not focus policies on sectoral basis.

However, the Fed analyses sectoral price movements to assess the spread of the inflation and its roots. This is also unwarranted as the Fed only looks at overall or macro inflation numbers and it does not have instruments to deal with sectoral inflation movements.

• The balance between the goals of price stability and maximum employment

The Fed Chair redefined it as the goal of maximum employment consistent with the price stability. This is a highly conceptual comment. As the government implements an unemployment benefit scheme, the Fed does not worry about unemployment rate and enjoys the freedom to decide interest rates.

• Fiscal contribution on the supply side and price stability

The Fed Chair commented that the Fed normally does not assess it as it only looks at the demand-pushed price movements and output growth. However, both prices and output are determined by both supply side and demand side factors and, therefore, the Fed has no statistical mechanism to separate the demand side and its impact from the supply side. Therefore, the demand-driven prices or inflation is only an old hypothesis.

• Federal debt unsustainability

The Fed Chair commented that the present debt stock is not at unsustainable levels yet, but its path is unsustainable. He believed that debt becomes unsustainable when debt grows faster than the economy (growth). In contrast, the US opposition and their economists outright state that the US debt is now unsustainable which is a historical debate. However, these are just hypothetical comments as there are no generally accepted standards for debt unsustainability.

Concluding remarks

• Above testimonies show a highly conceptual approach to the Fed's monetary policy. Therefore, many developing countries such as Sri Lanka also blindly adopt same approach disregarding macroeconomic contribution expected from central banks.

• The present conflict between the Fed and Trump Administration will have far reaching effects on the Fed in years to come unless the Fed facilitates the present government's domestic economic policy by considerably relaxing the monetary policy, given the Fed's broad economic growth and stability mandate. Further, current levels of Fed's interest rate policy will be unsustainable if the fiscal deficit and debt under the One, Big, Beautiful Bill passed into law on 4th July tend to rise faster as forecasted and if Treasuries yields tends to overshoot.

• Unknown tariff inflation cited by the Fed for the delay in interest rate cutting cycle holds no waters as central banks of many countries have already cut interest rates several times after the announcement of the new US tariff-based trade policy. The focus of such interest rate cuts has been to encourage growth and employment that are expected to be affected by the new US tariff policy.

• The Trump Administration suggests ample room available for interest rate cuts in view of the inflation fallen close to 2% target, falling US Treasuries yields and the government new policy of promoting domestic investments and output for higher living standards. Further, the Trump Administration contrasts with the Fed's approach for tariff inflation through higher domestic prices of imports. The view of the Administration's economists is that the cost of tariff is borne by exporting countries as the US presently produces almost all imported products and those countries have to cut export prices significantly if they wish to sell their products in the US at new tariff rates.

• The President's pressure on the present Fed Chair to resign immediately is rising on a daily basis while names of new candidates are revealed in the media.

• Therefore, the Fed's monetary independence is now being challenged as fictitious, unproductive and unhealthy in macroeconomic interest as it has a wide macroeconomic mandate.

• This will be a timely lesson to other countries who blindly follow the Fed's model of price stability-based mandate and independence. They must get ready to restructure respective central banking models as the Trump Administration is about to make a significant model change of the Fed soon.  

(This article is released in the interest of participating in the professional dialogue to find out solutions to economic issues affecting living standards. All are personal views of the author based on his research and knowledge on the subject and, therefore, the author has no intension to personally or maliciously discredit views and characters of any individuals or institutions.)

P Samarasiri

(BA (Hons) in Economics and MA in Economics)

(Former Deputy Governor, Central Bank of Sri Lanka)

(Former  Deputy Governor, Assistant Governor, Secretary to the Monetary Board, Compliance Officer and Director of Bank Supervision of the Central Bank, Former Chairman of the Sri Lanka Accounting and Auditing Standards Board and Credit Information Bureau, Former Chairman and Vice Chairman of the Institute of Bankers of Sri Lanka, Former Member of the Securities and Exchange Commission and Insurance Regulatory Commission and the Author of 13 Economics and Banking Books and a large number of articles published.)