When the US entered WWII, it required levels of borrowing never seen before in history. To meet these extreme conditions, the Federal Reserve willingly surrendered its control over interest rates, and with it, its independence. In their 1942 annual report, the Fed mentioned how they were doing everything “within the limits imposed by the exigencies of war” (Board of Governors 1942, 6), but not within the limits of conventional monetary policy. Was this a necessary wartime sacrifice, or was this a line that the Federal Reserve should fundamentally never cross? And how does the relationship between the Fed and the state from that period compare to the present?
The Fed was created in 1913 to be a centralized banking institution to fill the gaps of elastic currency, acting as a lender of last resort and providing discounting services which had led to continuous banking panics. The Fed has a dual mandate of promoting maximum employment levels and maintaining price stability through inflation targeting. The Fed’s main power is their direct control of the federal funds rate, and therefore monetary policy. They also act as a lender of last resort and regulator of other banks. To prevent short-term political bias from impacting long-term economic conditions, the Fed was designed to act independently from the state. This independence was tested after 1941, when the US entered WWII. The US had reached unprecedented levels of expenditures, with their cash outflow exceeding their income by $10 billion and national expenditures tripling from 1941 to 1942, eventually reaching a peak of approximately $95 billion in 1944. Cash deficit during this period averaged to about 30% of the contemporary net national product (Friedman and Schwartz 1963, 556-557). Financing this required cheap borrowing from the Treasury. In 1942, the Fed pegged the Treasury bill rates at ⅜% and long-term bond rates at 2.5%. The Fed also committed to purchase any government securities that would not get bought by the market during auctions (Friedman and Schwartz 1963, 556-557). This means that the Fed no longer had control over the monetary policy, and therefore money supply, which violated one of the most fundamental values of the Fed and central banks in general: its independence from state institutions.
During the period of war, this arrangement ended up working effectively. The government managed to have more funding for the war without overflowing itself with unpayable high interest. Although money supply nearly tripled during this time period, inflation was still under control (Friedman and Schwartz 1980, 129). To achieve this, the government imposed price controls and food rationing, which prevented excessive spending despite the dramatic surge in money supply. This meant that the velocity of money—which measures how fast money is exchanged in the economy—fell down due to the lack of available goods to purchase, which negated the effect of higher money supply (Friedman and Schwartz 1980, 142). The Fed itself acknowledged that such an accomplishment would not have been possible without direct state action, stating that inflation control “could be achieved only through concerted action by all agencies of the Government” (Board of Governors 1942, 3).
Once the war ended in 1945, the economic situation took a large turn. Since the US no longer found itself in wartime, price controls and rationing were removed in order to boost the economy once again, which led to an explosion in overall demand. Americans took out a lot of the money they were saving up during the war and began increasing their spending at high rates (Friedman and Schwartz 1980, 144). This meant that the Fed now faced a rising threat of inflation as the tools used to suppress it were no longer in use. The Treasury, however, greatly benefited from the low fixed costs of borrowing, and since the Fed was under commitment to support the Treasury with low rates, they were unable to raise them. Mark Toma argues that the peg was only sustainable under the narrow scope of the wartime environment. The inflationary pressures and growth in money supply stemming from the system were only manageable due to the fact that the Fed was only buying one type of government security (3-month Treasury bills at ⅜%) and that there was a high degree of public trust in the government at that time (Toma 1992, 631). This trust is argued to be a case of the rational expectations framework, which sees people feeling confident that inflation wouldn’t rise to uncontrollable levels due to the Fed only committing to buy one type of government security. Once the war ended, these conditions were no longer present, which consequently led to the levels of inflation increasing in the late 1940s (Toma 1992, 634-635). This is when the role of the state became questionable, as they were exploiting a wartime arrangement to get cheaper financing at the expense of price stability. In simple terms, the Fed asked for its independence back, but the Treasury refused.
In 1951, The Treasury-Fed Accord officially terminated the Treasury rate control established during the war. There were several fiscal factors that pushed the arrangement to end, which include: welfare state expansion, Cold War rearmament, and spending on reconstruction, which would have made it impossible for the Fed to control inflation (Toma 1992, 648). The tension eventually even involved President Truman pressuring Fed Governors in the White House. The Accord of 1951 marked the date from which the Fed had officially maintained its independence from the state.
The dynamic explored between the Fed and the state has become extremely relevant today. From early on in his presidential term, Donald Trump has again and again called for the Fed to lower rates, to which the Fed has pushed back, showing that, at least currently, the Fed intends to prioritize long-term price stability rather than becoming the government’s financial branch like during WWII. Trump has gone as far as to state that a litmus test for the next chair of the Fed after Jerome Powell will be their willingness to lower rates immediately. Powell has continued to face pressure, as the DOJ has threatened him with criminal indictment over building renovations. Donald Trump has also attempted to remove Fed Governor Lisa Cook from the Fed, which is the first time in American history in which a president has attempted this (Lobosco 2026). With Powell’s term ending in May 2026, the question of who Trump will appoint has been a subject of much discussion. Compared to how the state and the Fed interacted during WWII, it’s clear that the Fed has a much more established independence and lacks a sense of urgency to abide by the government like it had during the war. However, with these recent pressures, we may ask ourselves: will the Fed continue to remain separated from the state, or will history repeat itself once again? And if so, will it be a necessity like it was during WWII, or a short-sighted arrangement which will hurt price stability?
References
Academic/Primary sources:
Board of Governors of the Federal Reserve System. Twenty-Ninth Annual Report of the Board of Governors of the Federal Reserve System Covering Operations for the Year 1942. Washington, DC: Federal Reserve System, 1943. Federal Reserve Archival System for Economic Research (FRASER), Federal Reserve Bank of St. Louis. https://fraser.stlouisfed.org.
Friedman, Milton, and Anna Jacobson Schwartz. A Monetary History of the United States, 1867–1960. Princeton: Princeton University Press, 1963. https://doi.org/10.1515/9781400829330.
Friedman, Milton, and Anna Jacobson Schwartz. “World War II Inflation, September 1939–August 1948.” In From New Deal Banking Reform to World War II Inflation, 129–176. Princeton: Princeton University Press, 1980. https://www.nber.org/system/files/chapters/c11389/c11389.pdf.
Lobosco, Katie. “Jerome Powell’s Remarkable Advice to His Successor Speaks Volumes About His Battle with Trump.” CNN Business, January 29, 2026. https://www.cnn.com/2026/01/29/economy/federal-reserve-independence-trump.
Toma, Mark. “Interest Rate Controls: The United States in the 1940s.” The Journal of Economic History 52, no. 3 (1992): 631–650.
https://www-cambridge-org.myaccess.library.utoronto.ca/core/services/aop-cambridge-core/content/view/S0022050700011426?pdf
News Article:
Lobosco, Katie. “Jerome Powell’s Remarkable Advice to His Successor Speaks Volumes About His Battle with Trump.” CNN Business, January 29, 2026.
https://www.cnn.com/2026/01/29/economy/federal-reserve-independence-trump
A Global History of Banking 
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