The Fed in an Election Year: Independence Day

Clowns to the left of me, jokers to the right

A recent Yahoo article caught my eye: “Jay Powell pledges to keep the Fed above politics in 2024. It is never that easy.” Will the Fed succumb to political pressure?

One view assumes the Fed is politicized like the rest of Washington: “of course the Fed will want to do incumbents a favor by being dovish in an election year.” This is consistent with the literature on the “political business cycle,” where a politically sensitive central bank helps incumbents by gunning the economy into an election, dealing with the lagged inflation surge after the election.

Given how politicized Washington is these days, it is tempting to think that the Fed has been sucked into the swamp like other institutions. However, I would argue that the Fed remains one of the most independent institutions in the Federal government.

The Goat and the GOAT

It is important to understand the history of the Fed. Belief in political independence is baked into the DNA of Fed officials. They all remember, with a bit of embarrassment, how Chair Burns seemed to succumb to political pressure in the 1970s, making a series of excuses for letting inflation spin out of control. By contrast, Chair Volcker is revered for standing up to politicians, slamming on the brakes and breaking the back of inflation. Burns is the goat; Volcker is the GOAT.

As such the risk to the Fed doesn’t come from the inside, but from the outside.? There are two ways the Fed could be politicized. First, a politically motivated Chair could make it through the appointment process. In the past, the Senate has blocked some very bad Governor nominations, but perhaps that will change. Second, the laws governing the Fed could be changed, injecting politics into a technocratic process. For example, Administration officials such as the Treasury Secretary could added to the FOMC, or Congress could mandate regular “audits” of monetary policy decisions. This would enable Congress could bring the same professionalism to monetary policy as it does with budget policy.

No noticeable impact

I haven’t taken a formal look at Fed behavior in election periods recently. However, in the Greenspan days I did a simple exercise to test the impact of elections. I first estimated several Taylor-type rules to account for the economic drivers of policy. I then looked at the residuals—the unexplained movements-from this model for signs of political patterns. Using dummy variables for various “windows” around elections and for the party in power I found that elections had no noticeable impact. Indeed, on average the funds rate was a little bit tighter during elections than was warranted by economic conditions.

It is much harder to do such an exercise under more recent Fed chairs. With long periods of zero rates and QE and with Powell’s shift to a nonlinear response function it is impossible to summarize Fed policy in a simple equation. However, if the Fed has been politically compromised it has surely been quite subtle. ?

Recent chairs have had much weaker political connections than Greenspan. Both Bernanke and Yellen faced pressure from politicians but little if any from the White House. Trump put a lot of pressure on Powell, and at times he moved in the direction Trump wanted, but at other times did the opposite. In my view, Trumps anger at Powell’s alleged “disloyalty” is a good sign of independence.

Some pundits point to the 1965-80 Great Inflation, arguing that the Fed has already taken a big step down that path. Indeed, the Fed’s initial response to high inflation in both periods was clearly inadequate. However, the Fed has already corrected course with one of the most aggressive tightening cycles in history. The Great Inflation and Volcker’s dramatic stand against it was the result of a repeated failure to take sufficient anti-inflation action. By reversing course so quickly, Powell doesn’t need to be Volcker’s mini-me, he just needs to finish the job he has started.

If Powell is trying to help the incumbent party, he is doing a bad job of it. In political business cycle models, the Fed chair fights inflation early in the President’s term so they can go into the election with low inflation, low rates and strong growth. A politicized Powell should have front-loaded, rather than back-loaded the rate hikes.

Finally, if anything, the dysfunction in the rest of Washington has made the Fed even more determined to remain above the fray. With frozen fiscal policy, the Fed is the only game in town for managing the business cycle. No matter what they do they will face aggressive political attacks. Hence it is a waste of time to try to placate either party. Better to try to do the right thing and at least retain the respect of impartial observers. At this stage I’m expecting just two cuts this year—25 bp in both September and December.

In my next post, I will (1) argue against the idea of a long “black out” period around the election and (2) show that even if the Fed wanted to influence the election, at this stage its options are severely limited.