Monetary Policy at the Time of Elections

By Silvia Merler, an Affiliate Fellow at Bruegel who formerly worked as Economic Analyst in DG Economic and Financial Affairs of the European Commission. Originally published at Bruegel

Tim Duy’s Fed Watch says that, as expected, the Federal Reserve left policy unchanged this month and the statement itself was largely unchanged as well. The near term inflation outlook improved from September to November, and with the year-over-year impacts of oil prices falling out of the data, headline inflation will track back upwards, which is not a big surprise. With regards to the timing of the next move, Duy argues that the language suggests conditions are moving in the right direction, but the Fed is still waiting for some “further” evidence. A continuation of recent trends will likely be sufficient as the “further” evidence needed to justify a rate hike in December.

Would a Trump victory derail a hike in December? Duy does not think this is likely at this juncture, and we should rather be focusing on the labour market. A slowdown in hiring to something closer to 100k a month would probably end the downward pressure on the unemployment rate and raise questions about the Fed’s basic forecast that the unemployment rate will continue to decline in the absence of additional rate hikes. We get two employment reports before the December meeting. For the Fed to stay on the sidelines yet again, we probably need to see both reports come in weak. The bottom line is that the Fed is looking past the election to the December meeting for its second move in this rate hike cycle and probably it would take some unlikely softer numbers to hold them back again.

Greg Ip, on the other hand, writes in The Wall Street Journal that Tuesday’s election matters. Typically, the Fed is guided by the economic data and elections are just transitory nuisances with little significance for the outlook. But this is no typical election, as one of the candidates represents a dramatic break with economic orthodoxy – with promises of protectionism and tax cuts but few details. Trump’s election would dramatically raise uncertainty, which is the reason why the stock market has tended to go down when his odds of winning go up. For the Fed, lower stock prices translate into less wealth, which is negative for the outlook in its own right. Additionally, the Fed will assume that uncertainty in the rest of the economy will mirror what happens in the markets. All of this reduces the odds it would actually raise interest rates in December. Ip argues that the Fed can take politics into consideration without being motivated by politics: when political decisions can potentially change the course of the economy, the Fed has to incorporate that into its decisions. Thus, a Trump victory would probably cast enough of a pall over the outlook to give the Fed reason to delay its next rate increase into next year. Ironically, Mr Trump may discover that he, not Mr Obama, is the reason the Fed hasn’t tightened.

Richard Clarida, commenting the FOMC statement over at PIMCO’s blog, says that there was little expectation that the Fed would announce a hike in November. The committee members said nothing in their public remarks since the September meeting to suggest that a rate hike was under serious consideration this week. Indeed, the odds of a November hike as priced by the fed funds futures market were only 16%, and for at least the past 20 years the Fed has never moved when the market has priced less than a 50% chance of a move.

As for the balance of risks, the language remained in the statement after making its first appearance this year in the September Fed statement. This is relevant because it would be difficult for the Fed to justify a hike if it believed that risks were tilted to the downside, or if the outlook were so uncertain it could not even characterise the risks. Clarida does not think that the Fed is trying to signal that the odds for a December hike have diminished. A year ago, the Fed wanted to boost market odds of a hike when it thought those odds were too low. Going into today – with those odds at 70% – the Fed appeared to be content to make minimal changes to the statement only six days before the US election. Whereas in September 2016 three FOMC members dissented, at this month’s meeting dissenters were only two. So this Fed statement seems aimed at making as few waves as possible: it is a placeholder until the Fed next meets and a rate hike in December continues to be likely, if not a done deal.

Natixis’ Philippe Waechter argues that the Fed is ready for December, under the assumption that Clinton wins the election. He argues that the language on inflation is the only noticeable change in the language of this statement as compared to the previous one – together with the remarks on consumption that appears less strong than in September. The Fed wants to recover room for manoeuver in its monetary policy and this is the reason why it is by now ready to accept an increase in the rates. Nevertheless, it is also acting in a context where it needs to signal that it remains vigilant. In an asymmetric approach to monetary policy, the Fed prefers to act too late (at the risk of inflation) than too early (at the risk of a slowdown in economic activity).

Tiffany Wilding, again on PIMCO’s blog, looks at one indicator on which Fed’s officials have recently trained a lens: the labour force participation rate. The participation rate has risen 0.5 percentage point over the past year, and the rise has occurred despite demographic and other secular trends implying that it should have declined about 0.3 ppt. During the news conference following the Federal Reserve’s September meeting, chair Yellen highlighted this development as a reason to believe there is more slack in the labour market than previously thought.

Wilding argues that the rise is not primarily the result of previously discouraged workers reentering the labour force, but stems largely from a decline in the number of long-term unemployed individuals (25 to 54-year-olds) dropping out. Notably, the decline comes on the heels of a very elevated pace of dropouts in 2014 and 2015, suggesting only limited scope for additional improvement. On the surface, it’s a good sign that people are now looking for a job longer. However, the CPS data suggest the number of marginally attached and underemployed individuals as a percentage of the working-age population hasn’t declined significantly since the participation rate started to increase last year. Taken together, these developments could indicate declining and more limited labor market slack. With respect to the participation rate, Wildingbelieves that the demographic and other secular forces which have driven trend declines in the participation rate will likely take over again. She views participation rate trends as a downside risk to the case for two to three hikes in the federal funds rate by the end of 2017.

Meanwhile, Kenneth Rogoff says markets nowadays are fixated on how high the Federal Reserve will raise interest rates in the next 12 months. This is dangerously shortsighted: the real concern ought to be how far it could cut rates in the next deep recession. Given that the Fed may struggle just to get its base interest rate up to 2% over the coming year, there will be very little room to cut if a recession hits. The two best ideas for dealing with the zero bound (negative rates and higher inflation target) are off-limits for the moment. Of course, there is always fiscal policy to provide economic stimulus. But it is extremely undesirable for government spending to have to be as volatile as it would be if it had to cover for the ineffectiveness of monetary policy. There may not be enough time before the next deep recession to lay the groundwork for effective negative-interest-rate policy or to phase in a higher inflation target. But that is no excuse for not starting to look hard at these options, especially if the alternatives are likely to be far more problematic.

The Economist’s Free Exchange argues that not every argument for keeping interest rates low is a good one. Central bankers may be too keen to spot inflation in the data, but if monetary policy operates with a lag, it makes sense to raise rates before you hit the target, to prevent overshoot. When doves reject this logic, they are implicitly criticising the Fed’s 2% inflation target, not its strategy for achieving its goal. Inflation targets do not call for making up for past mistakes, and central banks should try to do what they say they are trying to do. This also means that in an equal and opposite situation where the Fed must bring inflation down after an upward shock, it should loosen policy while inflation still exceeds 2%. It is easy to dismiss these points as academic, given that inflation has been below target for too long. At present, the biggest threat to central bank credibility is clearly on the downside. But when doves deny the logic of changing policy in advance of achieving the inflation target, they overreach. The data show plenty to be dovish about: doves should simply point that out and, if they want a price level target, say as much.