Fed independence - If it is flexed, markets will suffer

When Fed Chairman Martin accidentally encountered ex-president Truman on the streets of New York years after Chairman Martin split with the Treasury Department on keeping rates low and controlled, Truman greeted him with one word, "Traitor!" So, goes the life of the independent central banker. - Story sourced FT and others

Truman actually appointed William McChesney Martin to the Fed Chairmanship from Treasury where he was undersecretary of monetary affairs. Martin negotiated the Treasury-Fed Accord of 1951, so it was assumed that he would follow the bidding of Truman once he was appointed Fed Chairman after the Accord. Chairman Martin actually guarded Fed independence and took a difference stance from the desire of the President and Treasury. He stopped the inflation of the early '50's but the cost to Treasury financing was significant.

There is currently no appointment or negotiation intrigue with the Fed and Treasury, but war-time budget deficits and the potential for inflation create a potential toxic misalignment of interests. The central bank independence question that is on the minds of most investors is not significantly different today than the policy conflict faced in the early 1950’s. Will the Fed do the bidding of the Treasury Department, or will it break with the fiscal authority and be independent when appropriate? 

In the depth of a recession, policy decisions between the Treasury and Fed are aligned. In the current case, the Fed provided immediate liquidity support to stabilize financial markets. It then provided continued quantitative easing in an effort to keep rates low and support the massive debt issued by the Treasury in order to offset the lockdown created to manage the COVID pandemic. 

The potential discord between the Fed and Treasury going forward is twofold, timing and intensity. One, most Fed officials seem to be believers in the policy choice that inflation should be allowed to overshoot the 2% target. In this case, there will be little immediate break from the Treasury if there is a rise in inflation. Fiscal and monetary policy are aligned although ambiguous. Two, the MMT meme has infected central bankers. That is, there is the belief that monetary policy can follow an approach of continued increase in their balance sheet in order to meet their full employment policy objectives without serious negative economic consequences. Again, Treasury and Fed policies are aligned. 

At what time will these alignments of interests diverge? Perhaps not in 2020, but it is possible in 2021 if the economy starts to return to normal. Given the relative speed at implementing policy, it will always be the Fed that will create policy alignment uncertainty. It will be the focus of all global macro managers to handicap Fed independence and their willingness to weigh inflation versus output gap. This has always been the case for monetary policy watchers, but the stakes are much higher this time.