Why The Fed Will Not Raise Rates

While expectations of an imminent Fed rate hike have dissipated over the last month, widespread speculation remains that the FOMC will raise rates this year, with futures markets pricing in nearly a 50% chance of a 25 basis point (bp) hike by late October, and another 20% chance of a 50 bp hike.

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

There are two reasons for these assertions. First, it's an election year. Second, payrolls are declining, a trend that will continue into 2009, with the pace accelerating. Let's examine the historical basis for each of these influences. 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.

Note that when Volcker raised rates nearly 10 points prior to the 1980 election, choking off economic growth, it spelled doom for Carter's re-election bid. There were heavy protests against the Volcker Fed, with bankrupt farmers driving their tractors onto the street in front of the Fed, blocking access to the building. And 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 Depression, most folks 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 President, who famously accused Greenspan of thwarting his re-election bid, saying "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-not enough to choke off growth-thus the incumbent won.

While the level of statistical significance of a policy action of a given magnitude isn't addressed here, nor is the correlation perfect, 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 cut as the Fed's next move, has to do with the FOMC's dual policy mandate: fighting inflation, which they do by raising rates, and maintaining "full employment," by cutting rates to stimulate borrowing, thus increasing business activity.

Striking a balance between these objectives is Bernanke's conundrum: raise rates, and you're hated for tanking the economy; cut them, and you feed everyone's hopes-but you also feed inflation.

Given the Fed's dual charge, I compared changes in the Fed funds target to the monthly change in nonfarm payrolls going back to 1980, five months after Volcker took over the Fed and introduced monetarism.

In only two cases has the Fed raised rates when nonfarm payrolls were falling. Both occurred in 1982, representing brief, temporary adjustments to an aggressive course of easing in the face of decades-high unemployment. Within one to three months, the easing resumed. At the time inflation was 5% to 8%, compared with about 4% now. However, the Fed has cut rates when payrolls are falling 30 times since 1980. Clearly, the Fed is steadfastly resistant to raising rates when jobs are being shed. Payrolls have fallen every month this year. If the payroll trend persists, we'll see a rate cut before we see a hike.

Two more reasons the next rate move will likely be downward: first, the Fed is unlikely to enact restrictive monetary policy at the same time it is making accommodations elsewhere. The second has to do with Bernanke himself. He has shown a willingness to cut rates in the face of rising inflation, but many question his inflation-fighting resolve, especially with the economy continuing to weaken and the credit crisis deepening. A Paul Volcker might buck the trend and raise rates. But to paraphrase Lloyd Bentsen's retort to Dan Quayle in the 1988 vice-presidential debate, "Mr. Bernanke, you're no Paul Volcker."

Brian Hague is CEO of CNBS, Overland Park, Kan. For info: www.cnbsnet.com. (c) 2008 The Credit Union Journal and SourceMedia, Inc. All Rights Reserved. http://www.cujournal.com/ http://www.sourcemedia.com/