6 Words From Ex-Fed Chair Jerome Powell That Could Change Everything for Wall Street

Wall Street runs on a handful of basic assumptions that most take for granted. One of the biggest: The Federal Reserve sets interest rates based on economics, not politics.

In late May, accepting the Profile in Courage Award at the JFK Presidential Library, the former Fed chair Jerome Powell said that the assumption could be in danger of breaking. He issues a six-word warning if that comes true: "The Fed's credibility would be lost.

Image source: Getty Images.

Why the Fed's credibility is the whole ballgame

Powell specifically addressed what happens when Fed officials are punished for maintaining their independence: "If any administration finds a way to remove Fed officials over policy differences, then future administrations will do so as well," he said. The public would stop believing the central bank acts in the country's interest, and with that belief gone, "the Fed's credibility would be lost."

He wasn't speaking hypothetically. The award committee honored him for refusing to bend to political pressure from the White House. Apart from public comments and social media posts, the administration launched a criminal investigation by the Department of Justice into Powell.

What this means for interest rates and your investments

While lower interest rates are generally good for markets, what's better is trust.

U.S. Treasuries are treated as the world's risk-free asset -- nobody seriously doubts the government will pay its bills. What investors may doubt is whether the dollars they get back will be worth much.

The Fed's job of fighting inflation is critical. As long as markets believe the Fed will defend its roughly 2% inflation target, Treasury buyers accept yields that are more modest. Lenders in the rest of the economy do too.

However, if the market loses trust -- if investors believe the Fed won't do its job properly -- then things start to fall apart. Regardless of the Fed's short-term rates, Treasury buyers demand higher rates, believing that their returns are going to get eaten by inflation.

This can lead to a feedback loop: Higher yields make the government's own debt more expensive to finance, which means more borrowing and more erosion of confidence, which pushes yields even higher.

And of course, this all has a direct impact on the real economy -- and the S&P 500 (SNPINDEX: ^GSPC). Borrowing costs for businesses rise, slowing the pace of investment, while consumers tighten their wallets as car loan and mortgage rates rise, reducing corporate earnings.

We're not there yet

To be sure, none of this is guaranteed. And while the tenor of the relationship between the Fed and the Trump administration is certainly different from past relationships, Warsh pledged under oath that Trump never asked him to predetermine rate decisions. And the DOJ case was dropped.

And bond traders, for all the political noise, are currently betting the Fed will raise rates by December.

Ironically, public pressure on the Fed could have the opposite effect the administration intends: Warsh may wish to raise rates to signal the Fed's continued independence.

The bottom line

Ultimately, Powell's comments are a warning of what could be, not what is. If the Fed does indeed lose independence, or at least the market believes it has, it would in all likelihood change everything for Wall Street. It would be a true paradigm shift -- and not for the better.

You can't control what the Fed does, and you can't control what this or future administrations do. What you can control is owning shares of durable, profitable businesses you believe in and giving them time. Maybe that sounds cliché, but it's always been the winning formula.

Johnny Rice has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.