Fed Independence Under Scrutiny as Political Pressure Builds

Fed independence faces renewed questions as political tensions rise, weighing on investor sentiment and the US dollar.

Fresh political attacks on the Federal Reserve are rattling markets, raising concerns over the central bank’s credibility. President Trump’s call for Governor Lisa Cook to resign – citing issues tied to past mortgage dealings – has reignited debate over the Fed’s independence and injected a new layer of political risk.

If Cook were to step down, the balance of the Federal Open Market Committee (FOMC) could tilt more dovishly. Governors Waller and Bowman have already dissented in favour of interest rate cuts, while Stephen Miran – nominated as a temporary replacement for Adriana Kugler – is expected to support more aggressive easing if confirmed in September. Such a shift would deepen divisions within the Fed and complicate the policy outlook.

This dynamic is contributing to a steeper US yield curve, as investors weigh the risk that prolonged political interference could undermine confidence in the institution. For the dollar, the danger is that credibility concerns re-emerge just as markets price in looser monetary policy.

So far, the greenback has managed only a modest rebound this week, edging higher against a basket of major currencies. Attention now turns to today’s flash PMIs for a near-term gauge of US economic momentum, before the spotlight shifts to Chair Jerome Powell’s speech at Jackson Hole on Friday. Markets will be watching closely for reassurances on Fed independence and clarity on the path ahead.

Euro Poised for PMI Test

The euro has been treading water in August, with EUR/USD stuck in a narrow range and volatility near multi-month lows. Despite a 12 per cent year-to-date rally, momentum has faded, with the pair anchored around its short-term moving averages.

Today’s eurozone flash PMIs could prove pivotal. Investors remain alert to signs of slowing growth, particularly after the latest ZEW survey showed German sentiment deteriorating sharply. Expectations dropped by 18 points, while the current conditions index fell deeper into negative territory – a warning sign for Europe’s recovery prospects.

Any downside surprise in the PMIs may pressure the euro in the short term. However, the broader foreign exchange outlook still hinges on relative growth dynamics. Earlier gains were fuelled by narrowing gaps between the eurozone and the US, and with American momentum slowing, those differentials could once again turn in Europe’s favour. If fiscal stimulus emerges later this year, the medium-term outlook for the euro could strengthen further.

Sterling at Risk as Real Yields Collapse

Sterling looks increasingly vulnerable as UK real interest rates tumble. Over the past year, inflation-adjusted returns have dropped from a peak of 3.3 per cent in September 2024 to just 0.2 per cent today. With inflation running at 3.8 per cent and the Bank of England’s policy rate at 4 per cent, real yields are now barely positive.

This decline suggests that financial conditions are loosening despite the headline rate remaining relatively high. It also casts doubt on whether monetary policy is restrictive enough to tame demand and steer inflation back towards target. Services inflation remains stubborn, while 12-month expectations hover near 4 per cent, prompting questions over the Bank’s recent decision to cut rates.

For the pound, lower real yields reduce the appeal of UK assets – particularly compared with economies where inflation-adjusted rates remain comfortably positive. FX options markets may soon begin to price in this risk, with skewed risk reversals signalling increased demand for downside protection.

Market odds of another BoE rate cut before year-end have slipped below 50 per cent, reflecting doubts that policymakers can afford to ease again while inflation is projected to peak at 4 per cent. Yet the risk of stagflation is growing, leaving the Bank with little room to manoeuvre. In such an environment, GBP/USD may find it difficult to extend rallies, while GBP/EUR is likely to remain rangebound.

Topics