About the author: Derek Tang is an economist at LH Meyer, a policy analysis firm.
When it comes to the U.S. Federal Reserve, what often comes to mind is its domestic, not foreign, policy. After all, chairs go to great pains to stress that the dollar remains the province of the White House and Treasury.
But the lines are blurred now that the U.S. has deployed its financial preeminence for greater effect. From sanctions policy to currency flows, the Fed and U.S. financial power are inextricably linked.
Washington’s sights are trained on China, what the Biden administration calls the “most consequential geopolitical challenge.” The Fed will be pulled into the fray by hook or crook, and perhaps to its long-term detriment. This might begin as soon as Powell’s next testimony to Congress.
Where the Fed’s remit collides with foreign policy is financial stability.
Often, the Fed is merely the agent to the state’s principal. When the Treasury conducts foreign exchange interventions or the State Department issues sanctions, the Fed’s job simply is to carry those orders out.
At other times, the Fed takes on an active role. As a dollar lender of last resort, it properly took it upon itself to stand up various dollar liquidity schemes, like currency swaps, during crises.
But in doing so, it effectively set up a hierarchy of nations: The large advanced democracies of the G7, then close allies, and finally the rest. This ranking could mess with the White House’s gathering of allies worldwide.
The Fed’s stamp of approval is powerful. Various countries who were not invited by the Fed to set up swap lines are eager for the halo effect of their currencies being advertised as safe by the U.S. These nations include European and Asian treaty allies in Europe and Asia, not to mention India, the Indo-Pacific counterweight to China the U.S. wants on side. The Fed, intentionally or not, is placing its thumb on the scale in foreign relations. Politicians will want a say.
Still, the Fed will not want to bite off more than it can chew.
For instance, the pandemic has changed the Fed’s relationship with Congress and the public at large. Chair Jerome Powell’s encouragement of emergency measures was praised, but subsequent inflation has surely left him reluctant to test the limits once expanded by emergency.
Case in point: As interest rates rise, the Fed is now booking negative net income on the portfolio of bonds it bought (known as quantitative easing or QE) to shore up the economy during Covid. For the time being it will not be a revenue source and will even accumulate a sum it owes Treasury. The Fed will come under glare for those losses, despite the tacit understanding that it would not be punished for having handed over its trading profits after promoting the recovery, not to mention a higher tax take.
If Powell didn’t know it already, he will soon: Any reassurances he received that Washington would come to the Fed’s defense can be sacrificed at the altar of political expediency.
The Fed now faces a new law proposed by members of both parties to subject it to much stricter oversight and disclosure.
High inflation—or perhaps consequently reduced political capital—could put the Fed under pressure to do the bidding of others.
One could, then, see the Fed being called on to join the growing coordination between government agencies to counter China, both by reinforcing U.S strengths and actively cutting China off at its knees. What could be more urgent than full-spectrum preparation? Various agencies must not work at cross purposes. A pandemic met the bar for emergency footing; so could cold, or hot, war.
Already we see pressure on the Fed to speed its work on central bank digital currency amid skepticism from some governors. Some politicians fear China’s head start creates an enduring sphere of influence.
The Fed knows that the price of this extra responsibility is extra scrutiny. Preserving its operational independence, if its mandate expands, will be a tough balance to strike. And that exposure could serve as pretext for political involvement more broadly.
Powell is a staunch defender of central bank independence. Memories of pressure from former President Trump to depreciate the dollar must fill him with dread. Resistance was easy to resist when the parties were divided. Now, the focus on China is bipartisan.
Still, one might say, Powell has been doing his part with Russia countermeasures.
But it’s one thing to fence off a big player in global finance. It’s another to countenance disruption from protracted conflict with a major trading nation embedded in global value chains and finance—even as the U.S., if not allies, are friendshoring.
Consider the threat of denying China’s access to dollar finance. For instance, it relies heavily on U.S.-controlled dollar financial system. The Fed has the power to cast doubt on the presumption that China will enjoy continued, unfettered access to the dollar financial system.
For example, the Fed could undermine the legitimacy of China’s Treasury securities holdings, and therefore its ability to maneuver in financial markets, either by directly limiting use of these funds or by indirectly flagging cause that other agencies can use to restrict China.
The issue isn’t execution but whether the Fed weakens the bluff by softening the blow. When other government agencies pile the pressure on China, the Fed might preempt potential turmoil by easing policy, which could offset the pain on China. The Fed’s stabilization instincts might contradict an expressly disruptive strategy that takes time to set in.
When global economies and markets are this connected, it is hard to enact policy that hurts only China without some cost to us and our allies, which is why ringfencing it off beforehand would lower the price of doing so.
Furthermore, a greater role at the cost of reduced operational independence could put the Fed’s, and therefore the nation’s, leadership in international economic and financial fora at risk. The Fed has defended its research exchanges with Chinese counterparts so it can understand the economy, its primary job.
At the end of the day, though, it might not be up to the Fed. With inflation high, it has less credibility to be at odds with unified calls for more muscular U.S. leadership.
For all the Fed’s forward guidance on rates, it might do well to set its boundaries for its foreign policy—before it’s too late.
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