Donald Trump has suggested that the Fed should cut interest rates by 1 percentage point and engage in a further round of quantitative easing. He wants to see monetary policy used to give a substantial boost to US economic growth at a time when inflation is below target. In a pair of tweets just before the meeting of the Fed to decide on interest rates, he said:
China is adding great stimulus to its economy while at the same time keeping interest rates low. Our Federal Reserve has incessantly lifted interest rates, even though inflation is very low, and instituted a very big dose of quantitative tightening. We have the potential to go up like a rocket if we did some lowering of rates, like one point, and some quantitative easing. Yes, we are doing very well at 3.2% GDP, but with our wonderfully low inflation, we could be setting major records &, at the same time, make our National Debt start to look small!
But would this be an appropriate policy? The first issue concerns the independence of the Fed.
It is supposed to take decisions removed from the political arena. This means sticking to its inflation target of 2 per cent over the medium term – the target it has officially had since January 2012. To do this, it adjusts the federal funds interest rate and the magnitude of any bond buying programme (quantitative easing) or bond selling programme (quantitative tightening).
The Fed is supposed to assess the evidence concerning the pressures on inflation (e.g. changes in aggregate demand) and what inflation is likely to be over the medium term in the absence of any changes in monetary policy. If the Federal Open Market Committee (FOMC) expects inflation to exceed 2 per cent over the medium term, it will probably raise the federal funds rate; if it expects inflation to be below the target it will probably lower the federal funds rate.
In the case of the economy being in recession, and thus probably considerably undershooting the target, it may also engage in quantitative easing (QE). If the economy is growing strongly, it may sell some of its portfolio of bonds and thus engage in quantitative tightening (QT).
Since December 2015 the Fed has been raising interest rates by 0.25 percentage points at a time in a series of steps, so that the federal funds rate stands at between 2.25% and 2.5% (see chart). And since October 2017, it has also been engaged in quantitative tightening. In recent months it has been selling up to $50 billion of assets per month from its holdings of around $4000 billion and so far has reduced them by around £500 billion. It has, however, announced that the programme of QT will end in the second half of 2019.
This does raise the question of whether the FOMC is succumbing to political pressure to cease QT and put interest rate rises on hold. If so, it is going against its remit to base its policy purely on evidence. The Fed, however, maintains that its caution reflects uncertainty about the global economy.
The second issue is whether Trump’s proposed policy is a wise one.
Caution about further rises in interest rates and further QT is very different from the strongly expansionary monetary policy that President Trump proposes. The economy is already growing at 3.2%, which is above the rate of growth in potential output, of around 1.8% to 2.0%. The output gap (the percentage amount that actual GDP exceeds potential GDP) is positive. The IMF forecasts that the gap will be 1.4% in 2019 and 1.3% in 2020 and 2021. This means that the economy is operating at above normal capacity working and this will eventually start to drive up inflation. Any further stimulus will exacerbate the problem of excess demand. And a large stimulus, as proposed by Donald Trump, will cause serious overheating in the medium term, even if it does stimulate growth in the short term.
For these reasons, the Fed resisted calls for a large cut in interest rates and a return to quantitative easing. Instead it chose to keep interest rates on hold at its meeting on 1 May 2019.
But if the Fed had done as Donald Trump would have liked, the economy would probably be growing very strongly at the time of the next US election in November next year. It would be a good example of the start of a political business cycle – something that is rarer nowadays with the independence of central banks.
- What are the arguments for central bank independence?
- Are there any arguments against central bank independence?
- Explain what is meant by an ‘output gap’? Why is it important to be clear on what is meant by ‘potential output’?
- Would there be any supply-side effects of a strong monetary stimulus to the US economy at the current time? If so, what are they?
- Explain what is meant by the ‘political business’ cycle? Are governments in the UK, USA or the eurozone using macroeconomic policy to take advantage of the electoral cycle?
- The Fed seems to be ending its programme of quantitative tightening (QT). Why might that be so and is it a good idea?
- If inflation is caused by cost-push pressures, should central banks stick rigidly to inflation targets? Explain.
- How are expectations likely to affect the success of a monetary stimulus?
According to the theory of the political business cycle, governments call elections at the point in the business cycle that gives them the greatest likelihood of winning. This is normally near the peak of the cycle, when the economic news is currently good but likely to get worse in the medium term. With fixed-term governments, this makes it harder for governments as, unless they are lucky, they have to use demand management policies to engineer a boom as an election approaches. It is much easier if they can choose when to call an election.
In the UK, under the Fixed-term Parliaments Act of 2011, the next election must be five years after the previous one. This means that the next election in the UK must be the first Thursday in May 2020. The only exception is if at least two-thirds of all MPs vote for a motion ‘That there shall be an early parliamentary general election’ or ‘That this House has no confidence in Her Majesty’s Government.’
The former motion was put in the House of Commons on 19 April and was carried by 522 votes to 13 – considerably more than two-thirds of the 650 seats in Parliament. The next election will therefore take place on the government’s chosen date of 8 June 2017.
Part of the reason for the government calling an election is to give it a stronger mandate for its Brexit negotiations. Part is to take advantage of its currently strong opinion poll ratings, which, if correct, will mean that it will gain a substantially larger majority. But part could be to take advantage of the current state of the business cycle.
Although the economy is currently growing quite strongly (1.9% in 2016) and although forecasts for economic growth this year are around 2%, buoyed partly by a strongly growing world economy, beyond that things look less good. Indeed, there are a number of headwinds facing the economy.
First there are the Brexit negotiations, which are likely to prove long and difficult and could damage confidence in the economy. There may be adverse effects on both inward and domestic investment and possible increased capital outflows. At the press conference to the Bank of England’s February 2017 Inflation Report, the governor stated that “investment is expected to be around a quarter lower in three years’ time than projected prior to the referendum, with material consequences for productivity, wages and incomes”.
Second, the fall in the sterling exchange rate is putting upward pressure on inflation. The Bank of England forecasts that CPI inflation will peak at around 2.8% in early 2018. With nominal real wages lagging behind prices, real wages are falling and will continue to do so. As well as from putting downward pressure on living standards, it will tend to reduce consumption and the rate of economic growth.
Consumer debt has been rising rapidly in recent months, with credit-card debt reaching an 11-year high in February. This has helped to support growth. However, with falling real incomes, a lack of confidence may encourage people to cut back on new borrowing and hence on spending. What is more, concerns about the unsustainability of some consumer debt has encouraged the FCA (the financial sector regulator) to review the whole consumer credit industry. In addition, many banks are tightening up on their criteria for granting credit.
Retail spending, although rising in February itself, fell in the three months to February – the largest fall for nearly seven years. Such falls are likely to continue.
So if the current boom in the economy will soon end, then, according to political business cycle theory, the government is right to have called a snap election.
Gloomy economic outlook is why Theresa May was forced to call a snap election The Conversation, Richard Murphy (18/4/17)
What does Theresa May’s general election U-turn mean for the economy? Independent, Ben Chu (18/4/17)
It’s not the economy, stupid – is it? BBC News Scotland, Douglas Fraser (18/4/17)
Biggest fall in UK retail sales in seven years BBC News (21/4/17)
Sharp drop in UK retail sales blamed on higher prices Financial Times, Gavin Jackson (21/4/17)
Shoppers cut back as inflation kicks in – and top Bank of England official says it will get worse The Telegraph, Tim Wallace Szu Ping Chan (21/4/17)
Retail sales volumes fall at fastest quarterly rate in seven years Independent, Ben Chu (21/4/17)
Retail sales in Great Britain: Mar 2017 ONS (21/4/17)
- For what reasons might economic growth in the UK slow over the next two to three years?
- For what reasons might economic growth increase over the next two to three years?
- Why is forecasting UK economic growth particularly difficult at the present time?
- What does political business cycle theory predict about the behaviour of governments (a) with fixed terms between elections; (b) if they can choose when to call an election?
- How well timed is the government’s decision to call an election?
- If retail sales are falling, what other element(s) of aggregate demand may support economic growth in the coming months?
- How does UK productivity compare with that in other developed countries? Explain why.
- What possible trading arrangements with the EU could the UK have in a post-Brexit deal? Discuss their likelihood and their impact on economic growth?
During the 1970s, commentators often referred to the ‘political business cycle’. As William Nordhaus stated in a 1989 paper. “The theory of the political business cycle, which analyzes the interaction of political and economic systems, arose from the obvious facts of life that voters care about the economy while politicians care about power.”
In the past, politicians would use fiscal, and sometimes monetary, policies to manipulate aggregate demand so that the economy was growing strongly at the time of the next election. This often meant doing unpopular things in the first couple of years of office to allow for popular things, such as tax cuts and increased government transfers, as the next election approached. This tended to align the business cycle with the election cycle. The economy would slow in the early years of a parliament and expand rapidly towards the end.
To some extent, this has been the approach since 2010 of first the Coalition and now the Conservative governments. Cuts to government expenditure were made ‘in order to clear up the mess left by the previous government’. At the time it was hoped that, by the next election, the economy would be growing strongly again.
But in adopting a fiscal mandate, the current government could be doing the reverse of previous governments. George Osborne has set the target of a budget surplus by the final year of this parliament (2019–20) and has staked his reputation on achieving it.
The problem, as we saw in the blog, Hitting – or missing – the government’s self-imposed fiscal targets is that growth in the economy has slowed and this makes it more difficult to achieve the target of a budget surplus by 2019–20. Given that achieving this target is seen to be more important for his reputation for ‘sound management’ of the public finances than that the economy should be rapidly growing, it is likely that the Chancellor will be dampening aggregate demand in the run-up to the next election. Indeed, in the latest Budget, he announced that specific measures would be taken in 2019–20 to meet the target, including a further £3.5 billion of savings from departmental spending in 2019–20. In the meantime, however, taxes would be cut (such as increasing personal allowances and cutting business rates) and government spending in certain areas would be increased. As the OBR states:
Despite a weaker outlook for the economy and tax revenues, the Chancellor has announced a net tax cut and new spending commitments. But he remains on course for a £10 billion surplus in 2019–20, by rescheduling capital investment, promising other cuts in public services spending and shifting a one-off boost to corporation tax receipts into that year.
But many commentators have doubted that this will be enough to bring a surplus. Indeed Paul Johnson, Director of the Institute for Fiscal Studies, stated on BBC Radio 4’s Today Programme said that “there’s only about a 50:50 shot that he’s going to get there. If things change again, if the OBR downgrades its forecasts again, I don’t think he will be able to get away with anything like this. I think he will be forced to put some proper tax increases in or possibly find yet further proper spending cuts”.
If that is the case, he will be further dampening the economy as the next election approaches. In other words, the government may be doing the reverse of what governments did in the past. Instead of boosting the economy to increase growth at election time, the government may feel forced to make further cuts in government expenditure and/or to raise taxes to meet the fiscal target of a budget surplus.
Budget 2016: George Osborne hits back at deficit critics BBC News (17/3/16)
George Osborne will have to break his own rules to win the next election Business Insider, Ben Moshinsky (17/3/16)
Osborne Accused of Accounting Tricks to Meet Budget Surplus Goal Bloomberg, Svenja O’Donnell and Robert Hutton (16/3/16)
George Osborne warns more cuts may be needed to hit surplus target Financial Times, Jim Pickard (17/3/16)
6 charts that explain why George Osborne is about to make austerity even worse Independent, Hazel Sheffield (16/3/16)
Budget 2016: Osborne ‘has only 50-50 chance’ of hitting surplus target The Guardian, Heather Stewart and Larry Elliott (17/3/16)
How will Chancellor George Osborne reach his surplus? BBC News, Howard Mustoe (16/3/16)
Osborne’s fiscal illusion exposed as a house of credit cards The Guardian, Larry Elliott (17/3/16)
The Budget’s bottom line: taxes will rise and rise again The Telegraph, Allister Heath (17/3/16)
Reports, analysis and documents
Economic and fiscal outlook – March 2016 Office for Budget Responsibility (16/3/16)
Budget 2016: documents HM Treasury (16/3/16)
Budget 2016 Institute for Fiscal Studies (17/3/16)
- Explain the fiscal mandate of the Conservative government.
- Does sticking to targets for public-sector deficits and debt necessarily involve dampening aggregate demand as an election approaches? Explain.
- For what reasons may the Chancellor not hit his target of a public-sector surplus by 2019–20?
- Compare the advantages and disadvantages of a rules-based fiscal policy and one based on discretion.
According to political business cycle theory, incoming governments tend to take harsh measures at first, when they can blame the cuts on the ‘mess they’ve inherited’ from their predecessors. And then two or three years later, as an election looms, they can start spending more and/or cutting taxes, hoping that the good will this creates will help them win the election.
So are we seeing the start of a new political business cycle with the start of the new Coalition government? The following two articles look at the issue.
Coalition will inflict cuts now and spend later to win a second term Guardian, Larry Elliott (17/5/10)
If you get all the bad news out at once, the only way left to go will be up. Or will it? Independent, Sean O’Grady (18/5/10)
- Explain what is meant by the ‘political business cycle’.
- Would the existence of a political dimension to the business cycle amplify or dampen the cycle, or could it do either depending on the circumstances? Explain.
- Does the existence of an independent central bank eliminate the political business cycle?
- Will the new Office for Budget Responsibility (see Nipping it in the Budd: Enhancing fiscal credibility?) help to eliminate the political business cycle? Explain your answer.