October 19, 2025
Observer Research Foundation India
By Srijan Shukla
As the winter approached in 1965, then–US President Lyndon B. Johnson invited the Federal Reserve’s Chair, William McChesney Martin, for a barbecue at his Texas residence along the Pedernales River. While Johnson’s Texas barbecues were quite a feature of his political folklore, the invitation for Martin wasn’t exactly courteous. The Fed Chair had been contemplating, rather publicly, raising interest rates, and Johnson wasn’t amused. The president intended to “grill” his Fed Chair into some sense. During the course of their meeting, Martin managed to communicate to Johnson that setting interest rates was the job of the Fed, and the president backed off.
This little incident from six decades ago is a timely reminder that control over monetary policy has always been a contentious issue. President Donald Trump’s public musings about finding ways to get rid of the Fed Chair, Jerome Powell, or attempts at firing Lisa Cook, a member of the Federal Open Market Committee (FOMC), seem unprecedented only if one forgets what President Johnson’s Chair of the Council of Economic Advisers (CEA), Gardner Ackley, had remarked in 1964: “I would do everything I could to reduce or even eliminate the independence of the Federal Reserve.”
In that sense, the recent slew of attacks by Trump’s executive on his central bank is arguably just an extreme manifestation of the inevitable discord between a government and the central bank—especially as the latter plans to tighten the monetary taps. Politicians always seek lower rates, even sometimes at the cost of inflation, and it’s the latter that hurts the average household the most in the long run. Central bank independence, by design, is an effort to mitigate that problem. Thus, if the recent Trump effort to scuttle Fed independence hopefully ceases, then everyone can return to business soon.
Yet, most participants in the global economy feel that the current crisis of Fed independence is significantly graver. Over the past few months, prices of gold and silver have risen meteorically. Even more curiously, as pointed out by TD Securities, Microsoft’s bonds are trading at a lower yield than US Treasuries. This shouldn’t be the case, given that US government bonds are considered the safest asset in the world. As Fed independence is challenged by the White House, it is easy to miss that a more fundamental monetary regime change might also be underway after four decades – bringing the low-inflation-low interest rates era to a close.
By Srijan Shukla
As the winter approached in 1965, then–US President Lyndon B. Johnson invited the Federal Reserve’s Chair, William McChesney Martin, for a barbecue at his Texas residence along the Pedernales River. While Johnson’s Texas barbecues were quite a feature of his political folklore, the invitation for Martin wasn’t exactly courteous. The Fed Chair had been contemplating, rather publicly, raising interest rates, and Johnson wasn’t amused. The president intended to “grill” his Fed Chair into some sense. During the course of their meeting, Martin managed to communicate to Johnson that setting interest rates was the job of the Fed, and the president backed off.
This little incident from six decades ago is a timely reminder that control over monetary policy has always been a contentious issue. President Donald Trump’s public musings about finding ways to get rid of the Fed Chair, Jerome Powell, or attempts at firing Lisa Cook, a member of the Federal Open Market Committee (FOMC), seem unprecedented only if one forgets what President Johnson’s Chair of the Council of Economic Advisers (CEA), Gardner Ackley, had remarked in 1964: “I would do everything I could to reduce or even eliminate the independence of the Federal Reserve.”
In that sense, the recent slew of attacks by Trump’s executive on his central bank is arguably just an extreme manifestation of the inevitable discord between a government and the central bank—especially as the latter plans to tighten the monetary taps. Politicians always seek lower rates, even sometimes at the cost of inflation, and it’s the latter that hurts the average household the most in the long run. Central bank independence, by design, is an effort to mitigate that problem. Thus, if the recent Trump effort to scuttle Fed independence hopefully ceases, then everyone can return to business soon.
Yet, most participants in the global economy feel that the current crisis of Fed independence is significantly graver. Over the past few months, prices of gold and silver have risen meteorically. Even more curiously, as pointed out by TD Securities, Microsoft’s bonds are trading at a lower yield than US Treasuries. This shouldn’t be the case, given that US government bonds are considered the safest asset in the world. As Fed independence is challenged by the White House, it is easy to miss that a more fundamental monetary regime change might also be underway after four decades – bringing the low-inflation-low interest rates era to a close.
Only Notional Independence
To make sense of this moment, several commentators like to return to the 1960s–70s. There is a lot of merit in doing so – not just because of similar macroeconomic conditions in the US and worldwide, but because it teaches us something far more fundamental about the context and dynamic nature of the Fed and, more generally, central bank independence. In this regard, Alan Blinder’s masterful book, A Monetary and Fiscal History of the United States, 1961–2021, is especially useful.
Following the assassination of President John F. Kennedy, Johnson took over the White House. Soon, he facilitated a major tax cut, which was dubbed the Kennedy–Johnson Tax Cut, given that the former had been working on it. This was followed by Johnson’s Great Society welfare push and, finally, the steep rise in defence spending owing to the Vietnam War. As expected, the massive fiscal expansion led to a rise in both growth and inflation. This was the context for Johnson’s summoning of Fed Chair Martin to his Texas ranch.
On paper, the Treasury–Federal Reserve Accord granted the central bank independence in 1951. But Fed independence was not remotely as entrenched until the late 1970s. Consequently, the Fed’s response was late and inadequate. By the time Nixon came to power in 1969, inflation was as high as 6.4 percent. Over the next couple of years, both fiscal and monetary policy would contract, resulting in a fall in inflation but also a recession. This was still textbook territory: if inflation gets too persistent, one tightens fiscal and monetary policy until it breaks. If recession is the collateral damage, then so be it. The monetary and fiscal policy contracted, but with a delay, and thus, inflation also came down with a lag.
After the said inflation was tackled, what followed was, without a doubt, the most dramatic denunciation of the idea of central bank independence adopted just two decades ago. Martin made way for Arthur Burns at the Fed, and what followed was two years of monetary and fiscal policy bonanza—all directed to ensure Nixon’s victory in the 1972 presidential elections.
The fiscal deficit rose by 1 and 0.5 percent through 1971 and 1972. Meanwhile, the M2 growth rate went from 2.5 percent in February 1970 to 13.1 percent in June 1971 and 12.7 percent in November 1972—perfectly in time for the elections. To make things worse, wage–price controls were put in place to ensure inflation didn’t rise. The extremely buoyant economic conditions—as exemplified by the growth rate of 6.9 percent in 1972—facilitated Nixon’s victory. This is what Kenneth Rogoff referred to as the ‘political business cycle’.
Once the election was over, both fiscal and monetary policy contracted, but the wage–price controls were also done away with. As inflation soared to the highest level since 1951, the first OPEC shock led to a major hike in crude prices, and inflation soared even higher. Interestingly, by now, the Bretton Woods system was also done away with, and countries were slowly moving toward floating exchange rates. The US economy was now in stagflation, and the Fed’s response has been characterised by Blinder as “schizopheric”. It first hiked rates and then eased them.
The entire decade was financial mayhem. As the 1970s were closing and inflation had just begun to decline, the second OPEC shock arrived, taking the inflation rate to as high as 14 percent. The 1965-82 period in the US is known as the era of the ‘Great Inflation’.
Volcker and the Birth of Fed Credibility
In 1979, a reeling President Jimmy Carter brought in then–President of the New York Fed, Paul Volcker, to take charge of the country’s central bank. Volcker unleashed a string of rate hikes – over 20 percent at one point – and an unprecedented tightening of the money supply. It brought inflation back under control but resulted in a deep recession and took unemployment as high as 10.8 percent. Years later, when asked how he broke the great inflation, Volcker’s response was: “by causing bankruptcies”.
This moment is widely considered the de facto birth of Fed independence and credibility. After all, the two are inherently interrelated. It is not sufficient for a central bank to be independent; it also has to demonstrate its credibility in delivering price stability. Yet, there is another feature of the Volcker Shock that doesn’t get enough attention.
“Now, after years of compromise and from a head-on attack on inflation, it was time to act,” writes Volcker in his memoir, Keeping at It. “The dollar’s ties to gold and to the Bretton Woods fixed exchange rate system were long gone. There was widespread understanding that the dollar’s value now depended on the Fed’s ability to control the money supply and end the inflationary process.”
Through the 70s, it wasn’t just the wage-price controls, the oil shocks, or the Carter fiscal stimulus that resulted in persistent inflation. A more fundamental regime change had taken place with the end of the Bretton Woods fixed exchange rate system, and central banks across the West had struggled to adjust to it. From the Bank of England to the Bundesbank to the Federal Reserve, the steep hike in rates – and their success in bringing down inflation – resulted in the birth of modern central bank credibility and independence.
A New Regime?
Returning to the current moment of the Fed crisis, it is increasingly evident that following the pandemic, a regime change has taken place yet again. Over the past five years, the Fed’s record has been somewhat mixed. Its inability to predict inflation owing to massive fiscal expansion and supply chain disruptions was a glaring failure. However, it did succeed in delivering a major victory by effectively bringing down inflation without causing a recession. The thing is, central banks don’t have the luxury of having mixed records – least of all the leading global central bank.
As Jamie Rush and co-authors argue in Price of Money, owing to a host of reasons – ageing of baby boomers, a surge in AI-related capital expenditure, supply chain reconfigurations, rising protectionism, and ballooning debt levels – the low-inflation-low-interest-rate era seems to be coming to an end. The most pressing among these is arguably the US public finance math.
The US now seemingly faces a new trilemma – where it’s getting difficult to sustain all three: a large debt pile, a high primary deficit, and low interest rates. Something has to give. To make things worse, the level of policy uncertainty unleashed by the Trump administration makes it a Herculean task to do monetary policy right.
This is a new regime the Federal Reserve now finds itself in. The caveat here is that it is still not clear whether this new regime has already materialised or it’s a work in progress. Future central bank credibility, especially that of the Fed, will, in large part, rely on ensuring it can predict that before markets do.
About the author: Srijan Shukla is an Associate Fellow with the Centre for Economy and Growth Programme and the Forums team.
Source: This article was published by Observer Research Foundation
Observer Research Foundation
ORF was established on 5 September 1990 as a private, not for profit, ’think tank’ to influence public policy formulation. The Foundation brought together, for the first time, leading Indian economists and policymakers to present An Agenda for Economic Reforms in India. The idea was to help develop a consensus in favour of economic reforms.
Observer Research Foundation
ORF was established on 5 September 1990 as a private, not for profit, ’think tank’ to influence public policy formulation. The Foundation brought together, for the first time, leading Indian economists and policymakers to present An Agenda for Economic Reforms in India. The idea was to help develop a consensus in favour of economic reforms.
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