Filenews 21 July 2025
By John Authers
The future of the Federal Reserve's independence has turned into a high-risk reality show. President Donald Trump blasts the head of state, Jerome Powell, as "hollow-headed" and "rigid" — the official announcement from the White House that Powell will be fired is revoked an hour later — and the list of candidates to replace him is growing, while making their own proposals, publicly.
Underneath this unpleasant spectacle, however, it is hardly possible to discern a coherent vision for a new regime for the central bank, which includes closer cooperation with the finance ministry. This is inherent in much of what the president has said. Kevin Wars, a former Fed governor and front-runner, laid out the idea in an interview with CNBC:
We need a new agreement between the Treasury Department and the Fed, as it did in 1951, after another period in which we increased our nation's debt and were stuck with a central bank that was working opposite to the Treasury Department. This is the state of affairs now. So, if we have a new agreement, then the... The Fed chairman and the Treasury secretary can describe to the markets clearly: "This is our goal for the size of the Fed's balance sheet."
This is a slightly strange way of characterizing events 74 years ago, when much of the extraordinary financial and governmental architecture built to fight the U.S. in World War II remained intact but had begun to wear out. It marked the only time a president has effectively fired the Fed chairman.
The 1951 Treasury-Fed Agreement
Despite what Wars said, the agreement reached in 1951 gave the Fed more freedom, not less. It had spent a decade intervening to keep both short- and long-term interest rates low. The Treasury demanded it—a policy that economists call "economic repression"—to limit the cost of servicing the debt incurred in waging the war.
By February, inflation had reached 21 percent. Fed governors, tasked with keeping price hikes under control, complained about being forced to monetize debt issued to finance a new war in Korea. In response, Harry Truman summoned the entire board of directors to the Oval Office, where, as he announced, he "pledged to support President Truman in maintaining the stability of government securities for the duration of the emergency."
This was news to the Federal Open Market Commission. Mariner Eckles (after whom the Fed building and its controversial renovation were named) had resigned as chairman three years earlier, but remained on the board (something the current White House is trying to prevent Powell from doing). He released the Fed's version of events. Then, he wrote in his memoirs, "the fat was in the fire."
The Treasury was forced to participate in the deal, through its Deputy Secretary of State William McKisney Martin. The Fed would support sovereign debt for a while longer, but it gained long-term independence in its current form.
The effects were drastic. Thomas McCabe, chairman of the Fed since Eckles took over in 1948, resigned under pressure. Truman replaced him with Martin. This looked like a takeover of the central bank by the Ministry of Finance. A rather unpleasant situation at a time when the Fed was opaque and barely communicated anything, would be much uglier in light of social media and television in 2025.
How the Fed used its independence
Martin's description of the position as "an escort who ordered the punch to be removed just when the party had really started" has since framed perceptions of the proper role of the central bank. The ironies are obvious. Powell's Fed failed as a companion when inflation rose in 2021 by keeping interest rates at the bottom — if fired, it will be because he refused to return the punch to the party in recent months.
Martin also became a staunch supporter of allowing the market to set the highest bond yields. He was unrepentant when people took losses on their bonds. During his speech to a group of investment bankers in 1955, he said:
Perhaps there are some, even in this audience, who occasionally feel nostalgic for the connected money market, which was created during the war and continued until the agreement between the Treasury Department and the Fed in March 1951 leads us back in the direction of a freer market. Free markets, like free economies, have a way of falling and rising, thus reminding us that our system is a system of profit and loss, which entails penalties and rewards.
All successive Fed presidents have followed this direction, with varying degrees of success. Turning the Fed into an arm of the Treasury Department may conflict with its goals of controlling inflation and unemployment. Janet Yellen, the only person to have served full four-year terms as head of both institutions, has said that lowering interest rates to reduce government borrowing costs would lead to turning the U.S. into a banana "that is going to start printing money to finance budget deficits... And then we will have very high inflation or hyperinflation."
The son of a St. Louis Fed chairman, Martin stayed in the position longer than anyone else. He survived even the most violent attack on the head of the Fed by a president, after his decision to raise interest rates at the height of the Vietnam War in 1965 drew the ire of Lyndon Johnson. Martin was invited to LBJ's ranch in Texas, where the president—the same bully as Trump, in his own way—pushed him into the room, shouting, "Martin, my boys are dying in Vietnam and you don't want to print the money I need."
The Vietnam War clearly caused inflation risks, which, in retrospect, the Fed did not do enough to address. Martin would say that he finally gave in "to my eternal shame." Then as now, the president sought legal advice on whether he could fire him (he couldn't). All of this was done in private, while Trump's verbal aggression was in public view and the issue was spending on a war rather than who benefits from the bounties and cuts – but the parallels are clear. Fed governors since Martin have found that their independence at times means taking on the president.
The tormented legacy of quantitative easing
Wars's claim is that the Fed has overtly supported the Treasury since 2008 through its massive bond portfolio, now worth $6.7 trillion. Before the global financial crisis, it owned less than $1 trillion. This inflated balance sheet is a legacy of the quantitative easing that the Fed adopted—with Wars as one of its governors—during the crisis. In fact, it was printing money. With interest rates artificially low, the normal signals of the capitalist economy were attenuated and the "zombie" companies avoided creative destruction.
Wars admits that there is no obvious need to cut interest rates when the economy is growing, unemployment is low, financial conditions are loose, and inflation remains slightly above target. He squares the circle by arguing that lowering interest rates will allow the Fed to start selling its bonds (a move that, as long as the other variables remain the same, will push yields up).
Wars, speaking at the Brookings Institution in 2015, said that in the context of quantitative easing, wealth creation in financial markets was "significantly higher than my former colleagues predicted," while economic growth was "noticeably worse."
I am concerned that we have created something that may or may not prove counterproductive. Profits have been extracted from the wealthiest and most sophisticated who see central banks trying to drive up asset prices to drag the real economy along.
A prominent observer with a similar view was the future President Trump. Asked about the Fed's possible hikes in September 2016, he said:
They keep interest rates low so that everything else does not fall. We have a very false economy. At some point, interest rates will have to change... The only thing that is strong is the artificial stock market.
That sounds hypocritical from a president who today wants interest rates low, but back then, the federal funds rate was well below the rate of inflation. Now, it is well above a significantly higher level of inflation and the talk of cuts is more intense. Trump and Wars seem to agree that quantitative easing has unfairly favoured the wealthy who own stocks.
Is it really that strange?
Wars argues that the Fed can move away from quantitative easing and soften the blow by lowering interest rates — which also helps the government cover its deficit. At the same time, he says the central bank should consider the distributional effects of its actions. With the population plagued by serious inequalities, this makes obvious political sense.
Peter Cir of Academy Securities suggests that the alignment of the Fed and the Treasury Department is "really not that crazy" and that the U.S. and other central banks have already compromised their "purity."
Why not just "define the curve"? The Fed has proceeded with quantitative easing (it bought government bonds). The Fed has done Operation Twist (bought and sold Treasury bonds to influence the shape of the curve). If the Fed is going to set interest rates in a world where long-term interest rates are probably more important than short-term interest rates, why not set them too?
But supporters of a new deal have yet to answer the argument that for capitalism to work well, higher interest rates must be set by the market, where so-called "bond vigilantes" can be an important tool of control over irresponsible policies – ask Lisa Truss.
The biggest argument against a new deal may be the "Big Beautiful Bill," through which Congress and the president increase the deficit with tax cuts by turning a blind eye to large fortunes. The Fed won and then maintained its independence by refusing to print money to help finance wars. Now she is being asked to fund a Great Beautiful Banana Tree. Why should it jeopardize its fight against inflation just to allow tax cuts?
