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The Fed, Elections and Rate Changes

Posted By Barry Ritholtz On March 15, 2004 @ 1:50 am In Finance,Politics | Comments Disabled

We have a Fed meeting this week. Conventional wisdom is that the Fed’s hands are tied. As is so often the case, conventional wisdom turns out to be wrong. Alan Reynolds of the Cato Institute explains:

“Common assumptions about how the Fed affects elections are not necessarily correct . . . The common idea that elections prevent the Fed from doing anything — to avoid looking political — is not based on [historical] facts. In 1980, the funds rate was slashed from 17.6 percent in April to 9 percent in July, before being quickly increased to 19 percent in December. Not exactly unchanged. In the nine election years since 1960, the Fed left interest rates roughly unchanged only twice, in 1976 and 1996.”

Surprising, right? Here’s where things get even more interesting: When the Fed is in an easing modality during an election year — 1960, 1972 and 1992 — the incumbent party lost two of those three times. While it might be counterintuitive, it actually makes a lot of sense: The Fed is easing because economic conditions are weak, and that’s typically bad for any incumbent.

The Fed also tightened four times in election years. “In the two clearest cases of the Fed funds moving significantly higher, 1984 and 1988, the incumbent party easily kept the presidency both times.” Again, if the Fed is tightening in response to economic growth, its a net positive. No one may like rate hikes, but if rates are moving higher in an election year, its much more likely to in response to a robust economic expansion, rather than a nefarious political tactic.

Hence, it doesn’t hurt the incumbent.

Consider the following:

• In 1960, the Fed funds rate fell from 3.9 percent in May to 2.4 percent in November. But Republicans lost the White House because the economy was in recession.

• 1992 was another case of “political” easing. George Bush lost that election (partly because he had raised taxes after promising not to — and right in the middle of the 1990-91 recession).

• The Fed raised rates from 9.5 percent in December 1983 to 11.6 percent in August 1984. Impact? Reagan won re-election by a huge margin.

• From December 1987 to November 1988, the funds rate was again increased from 6.7 percent to 8.4 percent. Impact: GOP retained the White House, as VP Bush became president.

Alan Reynolds: “In short, incumbent presidents usually do better when the Fed is pushing rates up than when it is pushing rates down, unless high inflation is involved (1980). This is not as paradoxical as it may sound. Falling interest rates are usually a sign of economic distress, while a reasonable rise in interest rates is a routine side effect of a vigorous economic rebound.”

The Fed and the Election To Come [1]
Alan Reynolds
Cato Institute, March 7, 2004


(Note: Alan Reynolds is a senior fellow with the Cato Institute)

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[1] The Fed and the Election To Come: http://www.cato.org/dailys/03-07-04.html

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