The Fed and the Political Business Cycle: A Cursory Look
So the Fed left interest rates unchanged in May in a year in which most economists predicted that the interest rates would rise several times.
What do the data show? For April the CPI rose 2.5% over the last 12 months, and 0.2% in April. Core CPI rose 2.1% over the last 12 months, suggesting that much of the inflation was driven by food and energy price increases, though for other not as volatile products as we have breached the 2% target the Fed uses as its inflation target. Further, unemployment rates in April fell to an 18 year low of 3.9%, and average hourly earnings increased by 2.6% over the past year. Now considering that the natural rate of unemployment is believed to be somewhere between 4.5% and 5%, and considering the numbers for wage growth and the ongoing impact of the tax reforms in increasing spending, one would have thought the Fed would have raised interest rates in their last meeting early in May. The Jerome Powell led FOMC held the benchmark federal funds rate at its existing level of 1.5%-1.75%. Admittedly the aforementioned numbers came out days after the Fed meeting, but these numbers should not come as a surprise to policy makers charged with the task of making such predictions and utilizing such foreknowledge in making decisions that keep the Fed in line with its mandate. In particular as well is the fact that the preferred measure of inflation the Fed looks at, the percent change in the price index for personal consumption expenditures, showed a marked rise in March to 2.0% from 1.7% in February, based on the past 12 months to the month in question. This data came out April 30 a day before the FOMC meeting. Actually these numbers and trends are outcomes that should be expected as I touched on earlier in the year in a prior blog post. So why would an assumedly independent Fed not raise interest rates to stave off what is obviously inflation waiting in the offing? The so called political business cycle phenomenon may come to mind here. The notion that macroeconomic policy tools could be manipulated by incumbent politicians to achieve immediate particular desirable economic objectives in order to improve their reelection chances even if such manipulation is dynamically inefficient and costly down the road. In this context one could surmise that with US midterm elections looming, what is desirable for incumbent politicians, at least from the perspective of the general public, is a satisfaction that unemployment continues to remain low. “It’s the economy, stupid” continues to ring loud and clear and haunt incumbent politicians seeking reelection. But what about inflation? Clearly we can see that higher product prices are being mitigated by the concurrent higher wages. In fact it is quite plausible to argue that the need to pay higher wages is in part driving price inflation, so that money illusion might still be rampant among the public. That is, the higher product prices may in part be the result of the necessary higher wages businesses have to pay in an economy where workers have now become scarce as unemployment rates fall. So what people see first are the wage increases, not realizing that the purchasing power of those wages are soon diminished or stay the same as product prices rise throughout the economy. So to tie this in with the notion of a political business cycle going on, in the US, as with most modern economies, the Central Bank, or as in our case the Federal Reserve System - the Fed - is charged with at least the mandate to keep a rein on inflation. In the US it is a broader mandate from Congress to promote the goals of maximum employment, stable prices, and moderate long term interest rates. To ensure that the Fed pursues these objectives free of political pressures and prejudice, that is to avoid the political business cycle, the structure of the Fed is setup to ensure political independence. However this setup is not entirely immune to political influences. Early this year Jerome Powell was appointed by President Trump and confirmed by the Senate, to replace Janet Yellen as the Fed Chair, who also chairs the Federal Open Market Committee (FOMC) - the body within the Fed responsible for setting the benchmark interest rate - the federal funds rate. While the FOMC makes decisions on the federal funds rate by voting, the Chair does exert a huge influence on this vote and usually the norm tends to be that the majority of the committee votes with the Chair on the direction of the federal funds rate. As a political appointee of some sort it could be seen as a political gesture for Powell to drive monetary policy in the direction favorable to the incumbent GOP lawmakers who may need to point to a strong economy to waive of the Democrats’ challenge to their majority hold in both the House and Senate in November. By keeping the federal funds rate steady, instead of raising them, the Fed apparently favors a policy that continues to stimulate spending growth, possibly even lowering the unemployment rate further, while risking an overheating of the economy in the form of higher than targeted inflation. So here is a credibility problem for the Fed. If economic decisions are being made on the assumption that the Fed would keep inflation below its target of 2%, yet its policy stance is to permit inflation above 2%, it creates uncertainty for economic choices, especially with respect to financial investments that have to account for expected inflation in inter-temporal transactions. There may actually be justifiable reasons for the dovish position being taken by the FOMC in keeping interest rates unchanged. The minutes of the meeting suggest concern over the flattening of the yield curve, and the precedence of how an inversion of the curve has preceded recessions, but this perhaps suggests why the Powell led FOMC might not want to raise rates and risk hastening an economic downturn, which will be sour for the reelection chances of incumbent politicians. We are however well past the Great Recession of 07-09, and its tepid recovery; and the Conference Board’s Leading Economic Indicators report for April projects continued solid economic growth for 2018. The expected policy should have been to raise the interest rates to slow down rising inflation. In my view, and this is not just with the present administration, the assumed autonomy in policy making may be tenuous in reality as monetary policy might actually be influenced by political pressures and not fully by an objective reading of the economy as suggested by the economic data. Of course this is a hasty conclusion and we need to see what the Fed does in June, and July, and...
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