Trump, Powell and the future of central bank independence

Welcome to Beyond the Benchmark, the EFG podcast with Moz Afzal.

Moz Afzal:

Hi everyone. So today we are going to have a central bank deep dive. Obviously a very, very topical topic at the moment and something that only the one and only Stefan Gerlach can help us navigate through it. So Stefan, welcome.

Stefan Gerlach:

Thank you very much Moz.

Moz Afzal:

So Stefan, as we stand today, it's the 17th of July, 2025 and we look at forecasts for or given by the market actually for Fed rate cuts for the rest of the year. We actually have two rate cuts priced in September and December and obviously Donald Trump is not too happy about that. He'd rather see a rate cut in July or probably would've preferred a rate cut in June or even earlier than that. And obviously he's putting a lot of pressure on Jerome Powell at the moment. So Stefan help us pass through all of this noise and with respect to Jerome Powell.

Stefan Gerlach:

So I think the key thing to have in mind here is that even if you change the chairman of the Federal Reserve, you may not change Federal Reserve policy very much. And I think there are two reasons for that. Scott Bessent is of course someone who would understand very well the dangers of just suddenly cutting interest rates by hundreds of basis points and he'd be very unlikely to do that. The other question is of course whether he has the power to do so. So policy in the Fed is set by the Federal Open Market Committee and he will have one vote on that and all the other characters will still be there. So you, it's like you change the conductor of the Vienna Philharmonic. I'm not sure how much you don't change the piece they're playing, so I'm not sure how much that will bring. Now I have been checking and my understanding is that the Federal Reserve Act establishes that there is a Federal Open Market Committee and that historically has been setting policy, but my understanding is also that the Federal Reserve Act doesn't actually specify that they have to vote or doesn't exactly specify how these decisions are taken. So one could imagine a situation where the chairman would come in and actually change the way the institutional arrangement, who sets policy, how does the FOMC set policy and so on and so forth. But that would be a big disturbance to US monetary policy and I'm not sure the markets would like that very much. So let's make a long story short. I think my first comment here is it's not obvious that policy would change very much.

Moz Afzal:

I think that's quite clear key. I don't think necessary people understand that they, I guess take Donald Trump’s word for it that whoever he changes it to will just go and start setting policies straight away. I don't think that's very obvious to most or maybe the markets are quite clear. I mean Jamie Dimon made some very key comments even a few days ago saying that this is a really bad idea. Just talk us through why is it a bad idea that he's changed or fired? Why is it bad for markets? Why is it bad for the global economy?

Stefan Gerlach:

So the standard idea or motivation for having independent central banks is that historically when central banks were, when monetary policy actually was set by politicians directly as monetary policy was in the UK up until 1997 as said by the chancellor, you had a situation where politicians have wanted to sort of boost the economy for political reasons and that has tended to generate a lot of inflation historically. And you've had this situation where inflation was very high but you didn't necessarily boost the economy in terms of economic growth very much so you ended up with excess inflation and people noticed that some central banks that were historically had been very independent. In particular, the Bundesbank and the Swiss National Bank had much lower inflation rates.

 And then there was a lot of academic research about 30 years ago that actually indicated or suggested very strongly that independent central banks have lower inflation but they don't grow more slowly and so on. And that sort of shifted the whole discussion in the direction of we should have central bank independence. So markets are worried that having a political head of the Fed will lead to more inflation in the US and yeah, they are worried that an attempt will be made to overstimulate the economy, perhaps inflate away the value of the public debt and so on. So markets will react very strongly if they think that this sort of low inflation policies that the Fed has pursued very successfully in the last 20 years or so if they would be out the window tomorrow.

Moz Afzal:

So in a world it does happen, what do you think the implications are for central banks around the world? Would that, because I for me, would that spark a chain reaction where suddenly the UK suddenly decides that they want to reverse the course from 1997 because Trump was able to do it? Is there a danger that there's a domino effect of everyone else who follows Turkey?

Stefan Gerlach:

This is a very, very hard and very deep question because I think one consequence of all these quantitative easing all these central banks buying government bonds is that the linkages between fiscal and monetary policy have become much closer. And as you're well aware, central banks these days are often making losses on these bond portfolios and of course it means that they repatriate nothing or they transfer no profits at the end of the year to the ministry of Finance. And this of course this is the problem in some countries. So I can well imagine that there would be people saying the central bank independence that was for a while. Perhaps we should rethink that. I can well imagine that we have that change reaction. Another change reaction we can have is the central bank say, whoops, the US is going to go for higher inflation. That means our currency here could appreciate very strongly and to prevent that from happening, we are going to match, there's going to be pressure on us to match the Fed’s interest rate cuts. So we could have a sort of contagion in terms of interest setting as well.

Moz Afzal:

Certainly can certainly spiral out I guess with the gold bugs and the cryptocurrency hacks suddenly become very, very excited. So going back to practicalities again, obviously Jerome Powell himself has made it very clear that he's not going to step down and in fact Trump does not have the executive power to actually fire him. What are the sort of strategies can Trump use to undermine the credibility of Powell?

Stefan Gerlach:

Well I mean if he wants to undermine the credibility of Powell, he's doing fine right now. And this is just not in Trump's best interest. Powell will be leaving next year anyway and so I really don't see why he would want to force Powell out a couple of months early. That's a very high price to pay for something that probably is not going to matter very much I think is if Trump appoint a new Fed chair, that person we probably also pursue policy in broadly similar ways to power limit. He or she may cut the interest rates or push for a cut or 25 or 50 basic points early on. They won't change things very much. So I think that the gain for Trump is very small and the cost could be very high, but of course if you want to be in the centre of media attention then this is a great thing to talk about. And I think that's probably partially why he does this is not very good for financial markets for the US economy, the stock.

Moz Afzal:

Yeah, so I guess the other point is thinking about the undermining here is whether he can already appoint someone very early, right? Well I guess be at least what, eight to nine months early, right? So you could already nest somebody in to agitate and create noise ahead of time. Is that likely again you think? Does that make any sense?

Stefan Gerlach:

Well I think the other members of the Federal Open Market Committee who votes if they're going to continue to vote, they will not be happy having someone who comes in eight to nine months early and causes trouble.They're committed to conducting monetary policy in the best interest of the US and they will not take kindly on someone just coming in. They're sort of trying to complicate matters. My suspicion is that Trump, if he could, he would appoint someone who would pursue very similar policies to what Powell would do and if he was appointed early as a shadow chair, as some people are suggesting, I think he would probably not say very much. He would not cause too much difficulties because that would undermine his position when he becomes the chair a bit later. So I don't think this is a good way to go.

Moz Afzal:

Clearly it's a live topic everybody is very fixated on. But I want to move on to the ECB, so don't really get too much opportunity to talk about the ECB, but certainly from my perspective, again thinking about financial markets and how things have been priced in, they played a blinder so far this year. I think if I go back 12 months, if you recall the ECB was going to be a little bit later in terms of interest rate cuts compared to the Federal Reserve. But as the economy and inflation conditions warranted, the ECB has pretty much been acting in line with expectations.

Stefan Gerlach:

Yeah, I think the ECB has actually done quite well and if you talk to them, they basically feel that they have overcome this inflation surge and there's of course a question of exactly how fast rates would be coming down, but I think the view they project is one in which the inflation burst has been overcome. Inflation is on its way south and so are interest rates and we just have to see how fast this goes. But I think they feel very comfortable with what they have achieved so far. I think they're probably a little worried about what might happen in the US and if there's some turmoil were to happen in US bond markets or in the US politics, how this could be transmitted to the European economy. I think they are worried that there would be a spike in long bond yields in the US and this would in some way be transmitted to the euro area, but I think they feel quite comfortable with what they have achieved so far. There are as you know very well, and as you have argued, there are sort of deeper problems in the European economy economies, the big fiscal problems for instance, the government debt problems. Now we have the increase in defence spending coming, putting additional pressure on government's fiscal balances. So there are problems no doubt, but I think they feel comfortable with the inflation part of there.

Moz Afzal:

I guess it also brings along the uncertainty created by tariffs and what the inflation outlook looks like as a result of tariffs I guess from ECB, they're being net beneficiary I guess as the currencies appreciated significantly, it has led to deflationary forces within Europe, which probably gives them a little bit more air cover than say the UK or even the United States. But are they worried about tariffs? Is that something that's on their horizon? Of course, of course they've got Russia, Ukraine, war, and as well as trying to turn around their domestic economy.

Stefan Gerlach:

So they are worried, I sense about the risk of a slowdown. Of course if the US introduces tariffs as they are doing, that will push up inflation in the US but not outside the US. As a matter of fact, I think the thinking in Frankfurt is that US tariffs will probably slow the global economy and probably by slowing growth, lower inflation pressures across the world. I think that's their main thought. Of course you could have problems global supply chains for some reason being interrupted and that leading pushing up inflation and so on. I think the main concern they have about tariffs is that this was slow growth in Europe and as you know, growth in Europe has not been very strong recently and the German economy, which is so export dependent of course could be hit very hard by tariffs. So yeah, this is not something that they're very happy about and you sense it to me, you talk to them.

Moz Afzal:

Yeah, yeah. So what do you think then the reaction function is at the moment on a nice glide path for maybe another one, two rate cuts the economy starts to pick up in 2026. It seems pretty clear and probably the clearest I think ECB policy has been for a very long time relative to market expectations. To be clear here, my sort of thought is what could upset it? Is it really a big problem in the United States? Long bond yields go out of control and so on and so forth. Do you think that's the biggest risk they're worried about?

Stefan Gerlach:

I think this is something they are surely quite worried about economic disturbances coming someplace in the US economy. I think they're also worried a little bit about the political problems that Europe are experiencing that also to some extent are related to the ones in the us. So in Europe, a number of countries, a number of large economies in particular France for instance Italy and so on, Spain have these fiscal problems and fiscal problems you can overcome if you can forge a political agreement among the major political parties that this is something that we have to sort out and let's not really play politics about that, but you need to have political agreement to do this and that is quite difficult and particularly now since you have far right parties that sort of feel a boost wind in their sails after the election of Trump in the US and that may make it much more difficult to forge political agreement to deal with to deal with these things.

Moz Afzal:

Well I think the biggest solution or to all of those ills is obviously economic growth. So maybe pivoting a little bit here to the contrast between say the US, UK and even Europe. And I think the discussions we've been having both on our client webinars and our discussions internally has been very much around this notion that Trump is just going for growth, he's taking a big bet that he's going to stimulate the economic growth. I mean Scott Bessent has been widely quoted as saying that he wants three three and three 3% inflation, 3% real GDP and 3% budget deficit as the way to go. And obviously that means as we've been discussing a 6% nominal GDP growth rate and is very much driven by the fact that they can get economic growth. It solves all their problems with respect to fiscal deficits and so forth. Now what are your thoughts about that mantra?

Stefan Gerlach:

If you just look historically at normal GDP growth in the US I mean since 2010 it has basically been less than 5% to 4%, something like that. You had higher growth and normal GDP growth than so in the 1990s, but then you had not the same focus on achieving and maintaining 2% inflation. So if you want to drive normal GDP growth up to 3%, sorry, inflation up to 3%, then the question is what will the Fed do about that? Will they change their 2% inflation target? I suspect wouldn't be very keen to do that. So it sounds a little bit unlikely that they will achieve that, but of course it is. It would be fantastic if they were to do that and it would be fantastic if they could reduce the budget deficit down to 3%. Doesn't strike me as very likely.

Moz Afzal:

No, certainly after a big beautiful bill that the odds of that happening is very difficult. But again, I think stimulating that growth and I think certainly for the stock market at least they've given the benefit of the doubt that it's growth conquering all and the stock market reacting to it. So I do find ways find, there's some parallels between the two, which doesn't immediately dismiss the notion that they can get that, but I think your point is very right. It's probably expensive, a higher inflation rate, which also will then mean that fixed income markets will of course apply a much greater risk premium to that. And of course if the Fed does indeed deliver on those rate cuts, you just get a naturally steeper yield curve that is reflected and we are gradually moving in that direction.

Stefan Gerlach:

Yeah, I was going to ask you that. I mean, how do you think markets would react if the Fed said we will no longer go for 2%, if you think three or three and a half percent is just as good and to achieve that, we will cut rates aggressively over the next two, three quarters?

Moz Afzal:

Yeah, look, I think to me what is beautiful about the 2% is quite frankly, if you look over history, it never stays at 2%. It either goes 1% or one and a half is three average at 2% I think is a good measure. And to me, what I like about the 2%, because it's so ingrained in society, when people go in for a wage increase in, they stick to that 2% as being something that's enshrined in logic from the central bank. And so whether that happens or not is another story, but you create anchoring, which of course is very, very important for inflation. And for me, I think the markets, maybe short term stock markets in particular cyclical stocks in particular would absolutely love a 3% inflation rate and they'll probably reflect that because it means that interest rates would be a lot lower of course, but you create this unhinging which then creates a spiral that you really can't get out of. So short term it may well be relatively positive, but the long term would be pretty negative I would say in terms of its actual impact because of anchoring at that 2% is so critical to normal functioning society and that change will be quite detrimental of the long term. I think that's something, my view, and I think the markets will take that view as well.

Stefan Gerlach:

That's very much the view the central banker would take. As you were explaining this, I was thinking most you should be central banker, they would love that answer. This is actually a concern you can stimulate in the short run. The short run, you can make things look much better, but cutting interest rates. But there comes a tomorrow and there is a future that we need to worry about and that is long relative to the benefits you might have today.

Moz Afzal:

Yeah, no, I completely agree with that. So just finalising this kind of discussion today is around this kind of north star that Trump has created around that Trump and his administration has created around strong economic growth, strong nominal economic growth and AI and cheap energy is quite critical to that. You get the sense that the US has a very clear directionality to it. They kind of know what they want to achieve and how they'll get there whether they get there or not, as we've just discussed, unlikely, but we understand what they're trying to do. And I think where stock markets are giving the benefit of the doubt to the Americans or the Americans administration, I contrast that with say the UK where Starmer just don't really have a strong plan or a plan that's actually believable. There seems to be a lot of flip flopping around government spending, social welfare spending. And clearly that's clearly articulated when it comes to actually, well how do we stimulate growth? Market doesn't really believe it, right? And I think that's why you've got this sort of long end of the guilt curve being so steep and worrisome and I think with the bond vigilantes will probably have a fuel day at some point.

Stefan Gerlach:

Yeah, I think there is a concern about what would happen. I mean, as you were talking about the plans for the Trump administration, I was thinking of Mike Tyson not a noted fiscal policy maker, but when he said that everybody has a plan until they get punched in the face. I mean that is what tends to happen to finance ministers. They have a plan, they want to cut taxes or they want to be increased spending or they want to do something and then some economical political development happened that they have not at all anticipated and plans go and go haywire.

Moz Afzal:

Yeah, absolutely. So Stefan that we'll wrap it up there. Thank you very much for spending the time with me on the podcast. So with that we'll wrap it up there. Thank you for listening to the EFG podcast beyond the Benchmark, and we'll speak to you next time.

 

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