Fed Independence During Elections: An Analysis of Decision-making and Political Pressure

The role of central banks in modern economies is pivotal, ensuring monetary stability through interest rate policies, inflation targeting, and influencing broader financial conditions. A key debate surrounding central banks is their independence from political influence, especially during election periods. Governments, facing reelection, may prefer policies that stimulate economic growth or temporarily boost employment to garner voter support.

This article delves into the dynamics existing between central banks and political actors during election periods, specifically focusing on the US realities. The goal is to assess the degree of central bank independence and behavior when elections loom.

Theory: Central bank independence and political influence

In theory, independent central banks act in the economy’s long-term interests, uninfluenced by the short-term political goals of governments. This independence is essential for maintaining credibility, especially in controlling inflation and fostering sustainable economic growth. However, the reality often suggests that despite formal independence, central banks may face subtle political pressures during election periods.

One model, discussed in Drazen’s Lying Low theory, demonstrates that while central banks are independent in non-election years, they tend to accommodate political pressure during elections​. Politicians may push for monetary expansion in such times, hoping for short-term economic gains that could improve electoral prospects. Although central banks are legally autonomous, the pressure to “lie low” or avoid significant policy changes before elections is well-documented, as seen with the Federal Reserve’s reluctance to raise or lower interest rates during election years​.

Case study: The Federal Reserve

The Federal Reserve (Fed) is one of the most influential central banks globally, and it is considered independent by design. However, various studies have shown that the Fed faces political pressures during election years. 

The Fed’s practice of “lying low” can be traced back to numerous incidents where it refrained from altering monetary policy in the months leading up to elections. For instance, Alan Greenspan’s comment in 1992 about the luxury of doing nothing until after the election illustrates how the Fed aimed to avoid being drawn into political controversy​:

“I wish we had the luxury to sit back and do nothing until after the election, as is the conventional procedure of the Federal Open Market Committee.”

The Federal Funds Rate is the interest rate at which banks and other depository institutions lend balances held at Federal Reserve Banks to one another overnight. This rate is directly impacted by the Fed’s decisions on the key rate. In the chart above we can see how it behaved during the last 35 years of intersections between monetary policy and elections.

For an “election period,” we will consider the 4 months prior to the voting day, as it is exactly during this period the candidates of the two parties start to publicly debate and gather voters for their cause. 

In 5 out of 8 of these election periods, the Fed steadied its monetary policy, leaving the key rate unchanged until one of the candidates triumphed. After that, 3 out of these 5 times it completely reversed its policy, lowering the rate when before it was higher and hiking it up when it was lower.

This policy reversal was driven not as much by political factors, as by economic ones: 

• In 2001, there was the Dotcom bubble burst, which prompted the Fed to heavily stimulate the economy.
• In 2016, the Fed tried to anticipate possible inflation rising above target but stopped raising rates because of disastrous economic readings from China.
• In 2020, the Covid pandemic happened, and inflation, as well as the key rate, started rising again only at the beginning of 2022.

The other 3 times, the Federal Reserve continued its current monetary cycle, cutting rates in July 1992, as well as in July 2008 (here, also because of the World Financial Crisis and the national need for stimulus), and hiking them during July 2004. 

From this analysis, it becomes clear that the Fed tries to stay as neutral as possible regarding elections. On the other hand, a clear trend during ruling party changes is visible.

When a rate hike happened during the second term in a row of either a democratic or republican president, the next term this party wasn’t given ruling power again. Also, this behavioral pattern recurred during Trump’s first term, but in this case, the Fed only continued from where it stopped rising rates in January 2016. 

In all these cases, the rate-hike phenomenon yet again underlines the negative impact of a hawkish monetary policy on public opinion.

Conclusion

Despite their legal independence, the Fed may act differently during election periods compared to non-election years. 

The reluctance to raise interest rates, a politically unpopular move, is especially evident in many election cycles. This is further supported by econometric evidence that shows fewer hawkish policy changes in US election years​. Other countries exhibit similar behaviors, though the degree of central bank accommodation varies based on the political structure and the bank’s legal independence.

On September 18, 2024, for the first time in 20 years, the Fed shifted its policy towards a more dovish one during the hot part of the election season, cutting rates by 50 basis points. As never before in the last 35 years an event of this importance happened in the July-early November timespan, there are more readings to this abrupt change in policy, than just the economic one.

Is the Fed just afraid of a recession? Does it just think it is high time to lower rates, or has it also received pressure from the current US administration, hoping to gather consensus with an easing policy? We cannot know that for sure. 

Nevertheless, the challenge for the Fed, as well as other countries’ central banks moving forward is to maintain their independence while managing these political pressures to avoid eroding their credibility and long-term effectiveness.

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