Why the Supreme Court's Ruling on the Fed This Week Is Good for the Stock Market

In a major decision this week, the Supreme Court ruled that the Federal Reserve has a historically unique kind of independence from the executive branch and, as a result, the president cannot fire a Fed governor without cause. And that's very welcome news for investors.

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The decision stems from President Donald Trump's attempts to fire Fed Governor Lisa Cook on allegations that she committed mortgage fraud in 2021 (Cook denies the allegations and the Justice Department investigation into her actions is ongoing).

Many observers of the investigation into Cook believe it was initiated to force her ouster from the Fed and replace her with a governor more amenable to the interest rate cuts Trump wants. The Trump administration also attempted to push former Fed Chair Jerome Powell out prematurely for the same reasons, they hold.

Had the court ruled that Trump could fire Cook without proof of wrongdoing, it would mean that the president (any president) could fire Fed governors at will, without cause. And that would allow a president to reshape the Fed to their liking, which would seriously compromise the Fed's independence.

Central bank independence promotes economic growth and healthy markets

It bears repeating that central bank independence -- which insulates these institutions from political pressure to conduct monetary policy in a specific way -- is critical to economic growth and stability, as well as the health of the stock market.

When consumers believe the Fed has the authority to keep inflation under control, they alter their own behavior in ways that mitigate inflation. By contrast, when they doubt the Fed's credibility, they begin to act in ways that make inflation worse. For example, if consumers expect prices to rise, they accelerate purchases of some items to avoid higher price tags in the future. The resulting surge in current demand drives prices higher, creating the very inflation that many anticipated.

Investors, too, are influenced by inflation expectations. When they believe inflation is going to rise because of political pressure on the Fed to lower rates when it should be hiking, they retreat from risk assets like stocks and move to inflation hedges like gold and silver.

So, inflation expectations can act as a self-fulfilling prophecy. And the Court's ruling alludes to this idea. According to the decision, which was written by Chief Justice John Roberts, "Not only the fact of independence but also the appearance of independence is key to the Federal Reserve's design."

Economic studies find a correlation between central bank independence and stock prices

In fact, economic research has found that countries with low central bank independence experience greater risks of market crashes. This happens because investors come to expect more interest rate cuts and fewer rate hikes. When rates do eventually rise, the risk of a market correction is much higher.

One particular economic study focused on Turkey, where the president removed the top officials of the central bank in response to resistance to rate cuts. It found that "political intervention in central banks has a robust, positive, negative, and significant impact on stock market outcomes."

Politicians naturally want lower interest rates, especially when elections are approaching. Lower rates can boost consumer spending and give the economy and the stock market a shot of short-term adrenaline -- exactly what keeps incumbents in office.

But in the longer term, what benefits markets most is low and steady inflation and incremental economic growth based on fundamentals like productivity and population growth.

So, the Supreme Court ruling barring Trump from firing a governor without cause is significant. That said, it's not an ironclad guarantee of Fed independence. The court was divided on the ruling, five justices to four. And after the ruling, Trump said he would find an alternative method of removing Cook from the Fed.

But for now, at least, investors can breathe a sigh of relief.

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