Monetary policy-makers in the US and Europe preparing for ground-breaking September interest rate decisions should consider some intriguing historical parallels.
Four and a half decades ago, a new central bank president was struggling to come to terms with the dilemmas of monetary stewardship. He earned the wrath of his powerful but vulnerable one-time mentor, now the country’s leader, by refusing to cut interest rates.
Financial storms blowing across the Atlantic were pushing the new central bank chief into monetary tightening that would exacerbate economic difficulties and, ultimately, drive his former boss out of office.
The parallels between President Donald Trump and freshly inducted Federal Reserve Chair Kevin Warsh on the one hand, and West German Chancellor Helmut Schmidt and Bundesbank President Karl Otto Pöhl on the other, are unmistakable.
In 1981-82, the shockwaves generated by the Fed’s end-1970s monetary tightening under then-Chairman Paul Volcker reverberated around the world. Pöhl was state secretary at the finance ministry under Schmidt in his previous role as finance minister.
Schmidt promoted his close confidant to Bundesbank vice president in 1977 and to the top job in January 1980. In view of the sharp fall of the Deutsche Mark against the dollar. Pöhl – abetted by his steely deputy Helmut Schlesinger – had no choice but to maintain very tight monetary conditions. This was in spite of considerable public pressure from both Schmidt and French Prime Minister Raymond Barre.
In 2026, the direction of causality – despite Europe’s relatively weak geopolitical position – appears to be the other way around. On 9 and 10 September, the governing council of the European Central Bank meets in Berlin to decide a probable 0.25 percentage point rise in the 2.25% deposit rate to counter the inflationary effects of the on-off-on US-Israel-Iran war.
On 15 and 16 September the Federal Open Market Committee gathers in Washington to ponder whether to raise the Federal funds target rate from 3.50% to 3.75%. Following Warsh’s apparent change of stance expressed in his 28 August Jackson Hole speech, the probability is rising that the Fed will tighten. Trump is not likely to be amused.
ECB influence on Fed
Europe’s move will, naturally, not be the main factor behind any Fed rate hike. Even so, the sight of the world’s second-most-important central bank having made, five days earlier, a sensible, well-signalled yet politically difficult decision to tighten policy in response to rising inflation is likely to influence at least some FOMC decision-makers.
The ECB will decide the tightening in spite of political turbulence in the two main countries of the euro area, Germany and France. Chancellor Friedrich Merz faces a debilitating test in the Saxony Anhalt regional elections on 6 September. President Emmanuel Macron bows out after the April 2027 presidential elections where left- and right-wing populist candidates are currently leading the polls.
Trump has been famously critical of the refusal of former Fed chair Jerome Powell (who remains on the Fed board) to cut US interest rates to meet the presidential ambition of lowering debt service costs. (Trump ignored the obvious issue – which was pointed out by Powell’s predecessor Janet Yellen – that wilful neglect of inflation risks would drive up rather than reduce long term borrowing costs).
Trump appointed Warsh in May – who was already on the Fed board in 2006-11 – partly because he believed that that the new chair would be more open to monetary easing than his predecessor. Warsh’s reminder last month that the Fed will be implacable in its anti-inflation resolve seems unlikely to have met White House acclaim.
Trump’s comment on 31 August that Warsh will ‘do what he has to do’ indicates that a possible rise in the Fed interest rate on 15 September would meet a more measured response than might have been likely under Powell. But it will be bad news for a president who faces a series of credibility tests ahead of the November mid term elections.
Bundesbank’s lessons from Henry II
The tendency of political appointees turning against their masters once they become central bank heads is a well-known phenomenon. Past Bundesbank presidents have been disparate characters, united by different forms of adversity. This form of clannishness seems to have been transmitted to the ECB.
To describe this stubborn institutional independence, Bundesbank insiders, with grim historical relish, draw on the saga of English King Henry II. Thomas à Becket, Henry’s chancellor, opposed the king after he was made archbishop of Canterbury in 1162 and was murdered in 1170 for his pains – a fate dramatised in T S Eliot’s Murder in the Cathedral.
The process under which outsiders often end up conforming for more than expected to straightforward principles of tight money is now internationally recognised as the Becket effect. This was on full display in 1981-82. Following a previous series of sharp German interest rate increases, the Bundesbank under Schmidt’s one-time protégé Pöhl responded to persistent D-Mark weakness by suspending its normal methods of lending to commercial banks, driving up money market interest rates in 1981 to 30%.
Political consequences in 1981
The Bundesbank’s monetary squeeze had political consequences. Shortly before the French presidential elections in May 1981 that produced victory for François Mitterrand, Barre wrote to Schmidt with a desperate plea for cuts in Bundesbank interest rates.’
‘I believe it would be very advantageous if the interest rates could be reduced to a more moderate level. This would promote an economic recovery in Germany and, as a result, in other countries’. Seizing on the chance to exert pressure on Pöhl and Schlesinger, Schmidt arranged for a copy of the Barre letter to be sent to Frankfurt.
Pöhl and Schlesinger discussed the issue with the Bundesbank directorate, then wrote to Schmidt dismissing any question of interest rate cuts. Schmidt, who had earlier been a prime instigator of the American credit squeeze, finished up as a victim.
In his last weeks in office, Schmidt maintained an increasingly bitter yet unrelentingly unsuccessful mission to persuade the Bundesbank to relax credit. Pöhl and Schlesinger made a clandestine trip – never previously documented – to talk to Schmidt at his family home in the Hamburg suburb of Langenhorn. Schmidt entreated the duo to cut interest rates. They offered him no more technical changes, such as a cut in banks’ minimum reserve ratios – now what the embattled chancellor wanted to hear.
In a climactic Bundestag debate in October 1982 that sealed the fate of his government and brought Christian Democrat leader Helmut Kohl to power after a parliamentary no-confidence vote, Schmidt underlined how severely his once-harmonious relationship with the central bank had deteriorated.
He called on the Bundesbank to ‘contribute decisively to a fall in interest rates’ to stimulate investment in the economy, adding, ‘I am warning about the consequences of deflation!’
The Bundesbank delayed substantive cuts in interest rates until summer 1993, when Schmidt was smarting in opposition.
How long the Fed will wait before it cuts rates – and Trump’s probably more precarious political position when that happens – are just two intriguing questions facing Europe and the US in coming months.
David Marsh is Chairman of OMFIF.
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