This post is a guest contribution by Asha Bangalore* of The Northern Trust Company.
There have been several queries recently about the independence of Fed policy decisions in election years. There is a growing suspicion the Fed may succumb to political pressure and implement/maintain expansionary monetary policy actions prior to elections to bring about favorable economic conditions to benefit incumbent political leaders. The underlying assumption is the Fed can manage the growth path of the economy to suit the fortune of politicians. This assumption is naïve from an economic standpoint for the following reasons. One, the impact of monetary policy actions is visible in economic data several months after the action has been implemented (about 6 months down the road), which implies that easy monetary policy needs to be in place by spring time such that the favorable economic results are seen prior to elections. Two, building on the previous point, there has to sufficient evidence to justify monetary policy action and at the same time it should work in favor of candidates seeking political office. This coincidence is hardly probable.
Looking back, historical evidence strongly supports the Fed’s independence with regard to monetary policy and underscores that Fed actions are entirely tied to the nature of prevailing economic conditions. Recessions of 1980, 1981-82, and 1990-1991 are a good place to start. As chart 1 indicates, the federal funds rate was climbing in 1980 and 1981-82 recessions even as the jobless rate was advancing. The main focus of the Volcker Fed was to rein in inflation (see chart 2) which was rampant in this period. Here is a case where Fed policy was entirely designed to address economic issues as opposed to political concerns.
Closer in time, the Greenspan Fed commenced lowering the federal funds rate in July 1989. Between July 1989 and December 1990, the federal funds rate was reduced 250 bps to 7.00%. The midterm elections of 1990 were held during a recession. The Fed cut the federal funds rate 100bps in 1990 spread over four months — in July, October, November, and December. Reduction of the federal funds rate in the October-November months was of no material benefit to political candidates.
In 1991, the Fed lowered the federal funds rate 300 bps to 4.00%. Prior to the 1992 presidential elections, the Fed cut the funds rate in April, July, and September of 1992, taking the federal funds rate to 3.00%. The recovery following the 1990-91 recession was a jobless recovery. The unemployment rate peaked in June 1992, well over a year after the recession ended in March 1991. Robust growth of real GDP began only in the first quarter of 1992. These episodes of monetary policy are compelling illustrations of the Fed’s independence vis-à-vis elections.
The midterm election of 2010 will take place against a background of an economic recovery which is projected to be a “jobless recovery.” The unemployment rate in our forecast is predicted to peak in the middle of 2010. The Fed is unlikely to reduce monetary accommodation until labor market conditions have improved and it is confirmed that the credit machine is functioning without support.
* Asha Bangalore is vice president and economist at The Northern Trust Company, Chicago. Prior to joining the bank in 1994, she was consultant to savings and loan institutions and commercial banks at Financial & Economic Strategies Corporation, Chicago.
Source: Northern Trust – Daily Global Commentary, November 30, 2008.
