Why the Fed Absolutely, Positively Will Not Raise Rates This Year

(Note: this is something I wrote several weeks ago, and never got around to posting here as I was unsure what I was going to do with it. I've since updated it, and it also appears as a commentary in our company's newsletter on our website.)

Okay, I should have written this on July 7 when I was first thinking about it, because Fed Chairman Ben Bernanke’s comments on July 15, along with events that have unfolded over the last several weeks, have made what I’m about to say more plausible and less contrarian. I prefer to launch my bandwagon when nobody else has yet boarded it, but now I have some company.

So be it. While the Fed left rates alone earlier this month, contrary to the expectations of most Fed-watchers a month or so ago, the current probability of a hike in September is 18%, according to Fed funds futures traders. That’s down from 52% a month ago. But a 25 basis point hike is still priced in at a likelihood of 28% for the October FOMC meeting and 33% in December, and contracts for both meetings reflect a small chance of a 50 basis point increase, with a very slight chance of a 75 basis point hike in December. Futures traders are thus far pricing in no chance of an ease. So there are enough proponents of a tightening bias still out there for me to be bold in saying:

It will not happen. In fact, I believe the next move will be a cut.

There are two reasons for my assertions. First, it’s an election year. And second, nonfarm payrolls are declining, and will continue to decline into next year, with the pace of job losses accelerating. Now, let’s examine the historical basis for each of these pillars of support for my prediction.

Since the Fed went monetarist in 1979 under Paul Volcker, there have been seven presidential elections. Let’s look at each in turn, using the table below for reference (sorry, I'm too tech-challenged to make it look like much of a table, but hopefully you'll get the drift).

Year Winning Party Fed Funds Change Fed Chairman
1980 Challenger +8.50% Volcker
1984 Incumbent -1.50% Volcker
1988 Incumbent +0.875% Greenspan
1992 Challenger -0.75% Greenspan
1996 Incumbent None Greenspan
2000 Challenger None Greenspan
2004 Incumbent +0.75% Greenspan

First, let’s explain the table. The “Winning Party” column should be intuitive, but for example, in 1988, when Reagan’s second term was up and Bush Sr. won the election, it’s noted “Incumbent” since the incoming President was of the same party as his predecessor. Conversely, when Clinton’s second term ended, Bush Jr. won the 2000 election as the “Challenger” from the opposition party.

The next column denotes the change in the Fed funds target rate from June 30 to November 30 of the election year – in other words, from about now until the month of the general election.

Note that when Volcker raised rates nearly ten points in the months prior to the 1980 election, thus choking off economic growth, it spelled doom for Carter’s re-election bid. You may recall – if you’re old enough – that there were heavy protests against the Volcker Fed, with bankrupt farmers driving their tractors onto the street in front of the Fed’s headquarters, blocking access to the building. You may also recall that Reagan’s campaign mantra was, “Are you better off now than you were four years ago?” With record high interest rates and the highest unemployment since the Great Depression, most Americans weren’t.

In 1984 Volcker eased a point and a half prior to the election, and Reagan won in a landslide. In 1988, Greenspan raised rates, but only modestly, not yet halting growth, and Bush Sr. retained the White House for the Republicans.

But in 1992, even though Greenspan had cut the funds target 75 basis points in the months prior to the election, many viewed it as not enough. Among them was the incumbent President, who famously accused Greenspan of thwarting his re-election bid with the quote, “I re-appointed him, and he disappointed me.” Clinton defeated Bush that year with the campaign slogan, “It’s the economy, stupid.”

Greenspan apparently learned his lesson. There was no change in the funds target in the months prior to the next two elections, in spite of a looming recession in late 2000. In 2004, the Greenspan Fed raised rates in the months prior to the election, but the change was less than a percentage point, and not enough to choke off growth, thus the incumbent retained the White House.

Now, I haven’t bothered to try to determine the level of statistical significance of a policy action of a given magnitude, nor have I correlated this with other related measures, for example, output growth or unemployment. And the correlation isn’t perfect: Greenspan cut rates in 1992, which should have helped Bush Sr., but the point was that he wasn’t cutting aggressively at a time when job growth still hadn’t rebounded and the economy, while growing again after the 1990-91 recession, was languishing.

The bottom line is this: central bankers are loath to give the appearance of influencing presidential elections. That is not an immutable law; if necessary, they will act. But given Bernanke’s comments that suggest the Fed basically doesn’t know what to do right now, with both the threat to growth and the threat to inflation escalating, the pending election further lends support to the Fed holding off on doing anything until after November. (The next FOMC meeting after the election is in mid-December.)

The second reason I’m predicting no rate hike, and indeed, a rate cut as the Fed’s next move, has to do with the central bank’s dual policy mandate. The Fed is charged with fighting inflation, true, and they do that by raising rates, at least under the monetarist regime that’s been in place since Volcker’s chairmanship. But it is equally charged with maintaining “full employment,” which is done by cutting rates to stimulate consumer and business borrowing, thus increasing business activity to the point that companies need to hire more people, creating job growth.

The Fed’s job is thus to strike a balance between these two mandates. It can certainly be a precarious one; last year I often wrote of Bernanke’s job as walking a tightrope, and alluded to the old Leon Russell song of the same name, which includes the lyrics, “One side’s hate and one is hope,” which is descriptive of Bernanke’s ever-increasing conundrum: raise rates, and you’re hated for sending the economy into a tailspin; cut them, and you feed the hopes of Wall Street and Main Street, but you also feed the inflation monster.

But I digress. I compared the Fed funds target to the monthly change in nonfarm payrolls going back to the beginning of 1980, just five months after Volcker took the helm of the Fed and introduced monetarism to the central bank (that was also the year of the Depository Institutions Deregulation and Monetary Control Act, which allowed deposit and loan rates to float freely, thus setting the stage for the S&L crisis – but that’s another story).

In only two cases has the Fed raised rates when nonfarm payrolls were falling. Both occurred in 1982, and both represented brief, temporary adjustments to an aggressive course of easing in the face of, as noted earlier, the highest unemployment since the Depression. Within one to three months of each move, the easing resumed. Also, at the time CPI year-over-year was still running in the 6-8% range, compared with 4-5% recently.

However, the Fed has cut rates when nonfarm payrolls are falling on 30 occasions since 1980. Given that the Fed has cut rates – looking at the funds target month-to-month – 72 times since then, and nonfarm payrolls have fallen in 76 months during the same span, I’d say the statistical significance of that pattern is pretty solid.

The upshot of this is that the Fed is steadfastly resistant to raising rates when jobs are being shed. Nonfarm payrolls have fallen every month this year thus far, with a total loss of nearly a half-million jobs. The losses are broadening across industries, and projections of a reversal of the trend are as scarce as – well, jobs.

Moreover, given the Fed’s solid consistency in cutting rates when job losses are mounting, it’s highly likely that, if the payroll trend persists, we’ll see a rate cut before we see a hike.

There are two additional reasons that I believe the next rate move will be downward. First, the Fed is highly unlikely to enact restrictive monetary policy at the same time it is undertaking accommodative actions. Bernanke’s recent announcement that he will likely keep the discount window open to investment banks into next year would contradict an easing of the funds target.

The other reason has to do with Bernanke himself. While the evidence presented above makes it unlikely that any Fed chairman would raise rates this year, Bernanke has certainly shown he is willing to cut rates in the face of rising inflation. In other words, he is more dove than hawk, especially when it comes to his actions. A Paul Volcker might have the resolve to buck the trend. But to paraphrase Lloyd Bentsen’s famous retort to Dan Quayle in the 1988 vice-presidential debate, “Mr. Bernanke, you’re no Paul Volcker.”