When Fed Chairman Alan Greenspan speaks, the markets listen. What they are listening for, as I have explained before, is not his views on fiscal policy but some hint about how long the Fed will try to keep the Fed funds rate at 1 percent -- a feat never before accomplished for even a single postwar year.
After the Fed's meeting in late January, a subtle shift away from talking about keeping rates down for "a considerable period" toward using the word "patient" had a surprisingly negative effect on stocks. Mr. Greenspan's last two appearances before Congress, by contrast, were thought to signal an inclination to keep rates down for a considerable period.
The market's anxiety about the inevitable cyclical upturn of interest rates has little to do with economics. Investors know interest rates cannot remain this low forever and that they will rise only in a rising economy. In early February, 91 percent of the blue chip forecasters thought the Fed would raise interest rates this year (and 9 percent were wrong). Most thought rates would start rising after the June 30 or Aug. 10 meetings.
Whatever the timing, we all know the Fed will let rates rise only if and when the economy is expanding at a decent clip. Higher interest rates will then be the consequence of good economic news, not the cause of bad economic news. So why has the stock market been so hypersensitive to any hint that the Fed may start letting interest rates drift up, even by a quarter point?
The most likely explanation is politics. In Susan Lee's Jan. 12 Wall Street Journal column, "Will Greenspan seal the Bush re-election?" she suggested that "a considerable period" was "a phrase that most players read as until after the November elections."
That echoes a widespread assumption that rising interest rates hurt an incumbent president's chances of re-election. The election outcome would not matter much were it not for the fact that the leading Democratic contenders have been pushing an agenda far more hostile to investors than Bill Clinton's "New Democrat" campaign of 1992. Sens. John Kerry and John Edwards threaten even more regulation and litigation expenses for business, protectionist retreat from global competition, grandiose new spending schemes, and abusing the tax and transfer systems to penalize extraordinary effort and entrepreneurship.
Common assumptions about how the Fed affects elections are not necessarily correct, however. Ms. Lee's piece was part of a lively debate about the Fed and elections following a Dec. 29 Wall Street Journal op-ed by Mickey Levy. He compared the fed funds rate in November of presidential election years with what it had been in December of the previous year. Mr. Levy concluded that monetary policy has not been influenced by election year politics, except in 1972, when Fed Chairman Arthur Burns allegedly eased it to help re-elect Richard Nixon.
Mr. Levy was challenged by two economists at the Institute for International Economics, Gary Hufbauer and Paul Grieco. They focused on the six months from May to October during election years and found fewer interest rate changes during those "critical" months. They also found that rates were more often pushed lower than higher during those months. This suggested an election-year bias toward ease. Yet neither Mr. Levy's December to November period nor his critics' May to October period really captures what was going on and how it related to elections.
The common idea that elections prevent the Fed from doing anything, to avoid looking political, is not based on any facts. In 1980, the funds rate was slashed from 17.6 percent in April to 9 percent in July, before being quickly increased to 19 percent in December. Not exactly unchanged. In the nine election years since 1960, the Fed left interest rates roughly unchanged only twice, in 1976 and 1996.
The Fed eased three times, in 1960, 1972 and 1992, yet the incumbent party lost two of those three. The Fed tightened four times, if you count the 1980 roller coaster, but the incumbent dropped out in one of those (1968). In the two clearest cases of the Fed funds moving significantly higher, 1984 and 1988, the incumbent party easily kept the presidency both times.
In 1960, the Fed funds rate fell from 3.9 percent in May to 2.4 percent in November. But Republicans lost the White House because the economy was in recession and Dwight Eisenhower promised to keep tax rates sky high in the hope of running a budget surplus. This was a prime example of election-year easing during Messrs. Hufbauer's and Grieco's "critical months," but it was scarcely well-timed to help Nixon beat John Kennedy.
And 1992 was another case of supposedly political easing, as defined by Mr. Hufbauer and Mr. Grieco. Yet the first George Bush lost that election partly because he had raised tax rates in the middle of the recession of 1990-91, but also because the Fed was extraordinarily slow to ease interest rates. The Fed funds rate was still 6.1 percent in March 2001, when the recession ended. It was then only very gradually reduced to 3.1 percent by November 2002. The Fed was not ardently fighting the 1990 recession until 1993 -- a case of too much too late.
The Fed raised the funds rate from 9.5 percent in December 1983 to 11.6 percent in August 1984, for no apparent reason except that the economy was doing very well. So what? Reagan easily won re-election by a huge margin.
From December 1987 to November 1988, the funds rate was again increased from 6.7 percent to 8.4 percent. That certainly did not keep former Vice President Bush from becoming president.
In short, incumbent presidents usually do better when the Fed is pushing rates up than when it is pushing rates down, unless high inflation is involved (1980). This is not as paradoxical as it may sound. Falling interest rates are usually a sign of economic distress, while a reasonable rise in interest rates is a routine side effect of a vigorous economic rebound.
It makes neither economic nor political sense to sell stocks cheap out of fear that the lowest interest rates in modern history are sure to move a bit higher, sooner or later. When the herd sells good stocks for bad reasons, I buy.