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The Politics of Monetary Policy

Just under a century ago, the Federal Reserve Act was signed into law by President Woodrow Wilson on December 23, 1913, creating the first true central banking system in the United States for the purpose of maintaining the stability of the US banking system during times of severe financial duress. The Act was implemented in part to respond to the 1907 Banker’s Panic when systematic liquidity essentially vanished. The Dow Jones Industrial Average fell precipitously and depositors lost confidence in the US banking system due to a series of speculative and unregulated bets within the commodity markets, creating an ensuing run on regional and local banks and trust companies. Interesting how history truly rhymes. After much debate over how the Reserve Bank should be designed — whether a centralized government entity or within the private sector — the Congress agreed that the Federal Reserve should be a combination of both the public and private sectors.

One point of seemingly initial consensus was that the central banking system should be an independent body, namely, having the ability to make monetary decisions without the approval of the executive or legislative branches of the government, and thereby avoiding conflicted or short term monetary decisions for political expedience. While the central banking system remained subject to Congressional oversight, this level of independence would allow the Federal Reserve the flexibility to focus on longer-term mandates such as stable interest rates and full employment, while also acting as a lender of last resort during ensuing financial panics.

“L’enfer est plein de bonnes volontés et désirs”

Translation, hell is filled with good wishes and desires. Or as Randy Travis might croon, “I hear tell, the road to hell, is paved with good intentions”. (Avid readers of the Pfennig will undoubtedly recognize that we will catch it from Chuck on that one!) Let’s face it, any institution residing within the 20001 zip code is going to have to manage some level political pressures. But in the case of the Federal Reserve, the more salient question may be what type of impact can monetary policy have on political events, and particularly significant at this time, the presidential election?

Lest we turn a financial commentary into a political commentary, it should be noted that the politics of monetary policy are by no means a recent phenomena, nor one which resides with any specific political party. By historical standards, one of the most egregious infringements of this independence occurred during the first term of the Nixon administration when the president appointed Arthur Burns as the chairman of the Federal Reserve with the implicit – perhaps explicit – direction to maintain an easy monetary environment ahead of the 1972 election, and Nixon’s re-election bid. While this loose monetary policy may very well have had a positive impact on the re-election of President Nixon for a second – albeit truncated – term, there is little argument that the easy money policy during this period was a sizable contributor to the high inflation experienced later in the decade.  More on that later.

As the New York Times pointed out in a recent article, “The Fed has announced policy changes in September or October during 10- of the past 15-presidential election years, dating back to 1952.”[1] Given this historical context, republican supporters should not feel uniquely victimized that Chairman Bernanke made the announcement on September 13, 2012 to extend this period of quantitative expansion with the implementation of QE-III. Not surprisingly, Chairman Bernanke responded to this exact question of independence during his press conference after the QE-III announcement, stating “We make our decisions based entirely on the state of the economy and the needs of the economy for policy accommodation. So we just don’t take those factors into account…”[2]

But does quantitative easing during an election year support the incumbent party, or conversely, does the lack of liquidity in the system hurt an incumbent party from retaining its position? What we do know is that quantitative easing was implemented to re-liquefy the market during the financial crisis of 2008. Furthermore, as Chairman Bernanke himself stated in his letter to the Washington Post immediately after the QE-II announcement in October 2010, that “Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending.”[3] Recognizing that there are an innumerable number of variables that can affect an election, we simplify the analysis to observe just one variable – the value of the equity markets during an election year.

The admittedly simplistic two charts that follow are nevertheless striking. Both charts map the absolute level of the S&P 500 Index against the value of the Intrade contract, representing the probability of the incumbent party winning the election for both the 2012 and 2008 elections.[4] For readers unfamiliar with Intrade, this is an on-line trading website or “prediction market” where individual investors and speculators can trade contracts with real money on the outcome of specific events ranging from politics, foreign affairs, weather, and even Emmy winners.

Source: Bloomberg, Intrade, Click to enlarge image.

For the 2012 election, there visually appears to be a close correlation between President Obama’s re-election probabilities – most recently showing at over 65% — and the recent strength in the level of the S&P 500 index. In addition to these two factors, we have also illustrated the various periods of quantitative easing and duration extension initiatives, and unsurprisingly also find a correlation between the those factors and the value of the market. So based on a very simple transitive property of these variables, one can certainly find reason to view Federal Reserve monetary policy as having an impact on elections.

While the remaining duration of the 2012 election environment will be determined in November, we thought it worthwhile to view the 2008 election in using the same criteria factors. Here again, we find the incumbent party’s popularity fall precipitously along with the equity markets during the early fall of 2008, coinciding with the financial crisis of 2008 which saw a dramatic fall in systematic liquidity after the bankruptcy of Lehman Brothers, the privatization of Fannie and Freddie Mac, and the initial inaction of Congressional leaders to agree on a banking bailout plan, or TARP, which was ultimately approved on October 3, 2008. QE-I was not initiated by the Fed until late November 2008, well after the 2008 election.

Source: Bloomberg, Intrade. Click image to enlarge.

Nevertheless, the amount of stimulus from this Federal Reserve body has been extraordinary from an historical standpoint. Since the announcement of QE-I on November 25, 2008, the Federal Reserve’s balance sheet has expanded from $900 billion in early 2008 to the current $2.8 trillion by the middle of September 2012.[5] And this does not include the additional $40 billion per month that will be added to the balance sheet with QE-III.

 

This unprecedented level of stimulus has had a deleterious impact on the value of the US dollar, as the free printing of money and the leveraging of the future raises concerns about the quality of the institution underlying the fiat currency, as EverBank World Markets has been informing readers for the past decade. As the dollar weakens, demand for assets priced in dollars similarly increases, which include commodities such as gold, oil, and agricultural goods, US manufactured goods, and stocks. These inflationary pressures, while positive for investors in these assets, has a negative impact on US consumers’ propensity to purchase these everyday goods, thereby slowing retail sales as consumers are resigned to have less of their disposable income to spend on non-discretionary items. And eventually leading to a slowing of US economic prosperity given consumer spending contributes roughly 70% of US GDP growth.

But at least the politicians are happy.

So how does this impact your investment decisions? Glad you asked. Ingrained in the DNA of our philosophy, we promote well diversified financial portfolios with an ever-present eye toward managing risk. As egregious monetary stimulus has the effect of driving higher inflation on those goods consumers actually purchase, individuals could place a portion of their financial portfolio into assets having inflation-protection components, including gold, silver, and currencies in countries with relatively strong underlying fundamentals, each of which should benefit during periods of high inflation and US dollar weakness. Diversifying financial portfolios both geographically and in terms of asset selection can help balance portfolio performance throughout the fluctuations of these global monetary cycles.

Sincerely,
Chris Gaffney
SVP & Director of Sales
EverBank World Markets, a division of EverBank
800.926.4922

 

[1] “Economic Stimulus as the Election Nears?  It’s Been Done Before”, New York Times, September 11, 2012.

[2] “Transcript of Chairman Bernanke’s Press Conference, September 13, 2012”, Federal Reserve Board, September 13, 2012

[3] “What the Fed did and why: supporting the recovery and sustaining price stability” by Ben Bernanke, Washington Post, November 4, 2010.

[4] Intrade, Bloomberg, September 28, 2012

[5] Bloomberg, September 20, 2012.

 

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