The Fed Risks Helping Trump
Given Donald Trump’s rather inconsistent and worrying statements about his plans for the Federal Reserve, it would be ironic if the central bank provided the impetus that carries him over the finish line in this November’s presidential election. But there is a small chance that might happen.
The Fed is poised to raise interest rates again, after raising them in December for the first time in more than nine years. Janet Yellen, the Fed chair, said last month that if the economy continues to do reasonably well, the central bank will hike interest rates this summer or fall. Some non-hawkish Fed governors have echoed her statement. Markets seem to believe that the Fed is now serious about this.
Why might this help Trump’s presidential bid? Because rate increases have the capacity to hurt the economy. When Paul Volcker, Fed chairman at the time, raised rates sharply in the early 1980s to wring inflation out of the economy, two sharp recessions followed. Here’s the history, in pictures:
Macroeconomists, as well as the general public, have widely interpreted this as clear evidence that rising rates can have a damping effect on economic activity. This episode was key to the development of New Keynesian models of monetary policy, which are now used by most central banks.
Volcker’s rate hikes were enormous -- about 10 percentage points. The Fed’s current plans, which envision a few percentage points at most, might seem like small potatoes in comparison. But it isn’t just rates themselves that matter for the economy -- it’s people’s expectations of future rate increases. If people see a Fed hike as a policy regime shift -- the first in a long cycle of tightening -- it could have the same effect as if all the tightening was done in a single day. In other words, the perception of a turning point might be a big event for markets and for the economy.
If growth did take a hit, it probably would be a windfall for Trump. Economic conditions don’t necessarily determine the results of presidential elections, but they do appear to matter. If higher rates caused the perception of a policy regime shift, and that made growth decline in the coming months, that could make the difference in a very close election. It isn’t a likely scenario, but it’s possible.
In fact, there are allegations that the Fed has tipped the scales for Republicans in the past. Political scientists William Clark and Vincent Arel-Bundock wrote a paper in 2013 claiming exactly this. From their abstract:
We show evidence from the United States that interest rates (a) decline as elections approach when Republicans control the White House, but rise when Democrats do; and (b) are sensitive to the inflation rate (output gap) when Democrats (Republicans) are in the White House. Thus, the Federal Reserve is a conditional inflation hawk. Since the Fed became operationally independent in 1951, the Republicans have exhibited a decided electoral advantage in presidential politics.
The authors show how rates generally rose throughout the Kennedy, Johnson and Carter administrations, reaching their peak about the time Jimmy Carter was defeated by Ronald Reagan. But rates fell dramatically and steadily during the Reagan and George H.W. Bush administrations, and even more during the administration of George W. Bush.
I’m skeptical of drawing hard conclusions, because of the small sample involved. But it’s an unsettling reminder that the Fed has the ability to affect politics.
It seems highly unlikely that the Fed would be in the tank for Trump. But it’s also true that Trump has tried to publicly bully the Fed, as he bullies many others. Last fall, he accused Yellen of keeping interest rates low as a favor to President Barack Obama -- essentially the opposite of what Clark and Arel-Bundock allege. So Trump knows what’s at stake, and the pressure is on.
The Fed should do what it thinks is best for the economy without regard to whether it helps or hurts any presidential candidate or political party. But my personal opinion is that rate hikes just don’t look that necessary right now. The labor market doesn’t seem to be doing well. As my Bloomberg View colleague Narayana Kocherlakota mentioned in a recent article, inflation is still very subdued. Core inflation -- which excludes food and energy -- is comfortably below the Fed’s 2 percent target. Economic indicators look stable, but they certainly don’t indicate a takeoff in growth or anything like the kind of overheating that would put the economy in danger of a spike in inflation.
So it would be a tragedy if the Fed were to raise interest rates for little reason, at exactly the right time to tip Donald Trump into the Oval Office. For the country’s sake, I hope it doesn’t turn out that way.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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