Economics, politics and the federal funds markets: does the Fed play politics?

Abstract

No, the Fed does not appear to play politics with respect to setting the federal funds rate. We examine the federal funds spot and futures rates to infer the Fed's response to political pressure from partisan politics during election and nonelection years. We find little evidence that political variables influence either market, suggesting that spot and futures traders act as if the Fed's behaviour is similar across election and nonelection years. Our evidence suggests that federal funds traders believe the Fed generally behaves in a politically neutral fashion.

Keywords:

• monetary policy
• reaction functions
• politics

JEL Classification:

• E44
• E58

Acknowledgements

The authors thank James Zeitler for valuable insights and the Hughey Center for Financial Services and Olga Otborkina for assistance with the data. The authors also thank an anonymous referee for very helpful suggestions.

Notes

¹ Hamilton and Jorda (2002) cite internal Fed documents suggesting that the Fed has been explicitly targeting the federal funds rate since 1989.

² 2–3 November 2010 minutes of the FOMC. Available at http://www.federalreserve.gov/monetarypolicy/files/fomcminutes20101103.pdf (accessed 12 June 2010).

³ The Fed had some trouble in 2008–2009 maintaining the daily spot rate close to its target level. This is likely due to the instability and uncertainty in the financial markets combined with the introduction of new policy tools.

⁴ See Alesina et al. (1997).

⁵ Our sample period ends in 2007 to avoid the unprecedented changes in policy precipitated by the recession that started in December 2007.

⁶ Nordhaus (1975) provides the first foundations for political business cycles. With regard to monetary policy, such cycles are possible for any or all of the reasons stated above.

⁷ See, for example Mishkin (2010).

⁸ See, for example Bernanke's op-ed article in the Washington Post. Available at http://www.washingtonpost.com/wp-dyn/content/article/2009/11/27/AR2009112702322.html (accessed 12 July 2010).

⁹ They also find that the Consumer Confidence Index is superior to the University of Michigan's Consumer Sentiment Index in terms of its ability to forecast consumption. To our knowledge, however, no one has investigated how consumer confidence measures influence Fed policy-making decisions.

¹⁰ See, for example Bernanke and Kuttner (2003) and the references therein.

¹¹ See, for example a speech by William Poole at http://stlouisfed.org/news/speeches/2001/09_05_01.html (accessed 12 June 2010).

¹² One obvious method to discern the data that affects the Fed's policy decisions is to examine the minutes of the FOMC meetings. These are now released with a 3-week lag, but contain a detailed record of the variables discussed at a particular meeting. Perusal of these minutes provides a large of array of economic data that the Fed monitors: employment, various measures of inflation, industrial production, capacity utilization rates, GDP growth, labour market conditions, energy prices, etc. However, it is not possible to discern which variables carry more weight with the FOMC than others. The minutes provide little clue about which variables really matter to the Fed.

¹³ The frequency of target rate changes has varied over the years. For example, during the 1974 to 1979 period, the Fed changed its Funds rate target 98 times, but the number of changes during 1984 to 1989 was substantially less – only 32 times. In recent years, the frequency of Funds target changes has accelerated with a sharp downturn in the economy. For example, there were 14 changes in the Funds target rate during January 2001 to June 2003. Available at http://www.ny.frb.org/markets/statistics/dlyrates/fedrate.html (accessed 12 June 2010).

¹⁴ Contracts exist for up to 18 forward months. However, only contracts for the next 3 months usually enjoy thick markets. The CME Group 30-day federal funds futures contract calls for delivery of the interest paid on $5 million overnight federal funds held for 30 days. The contract is cash settled against the monthly average of the daily federal funds effective rate. Prior to the merger between the Chicago Board of Trade (CBOT) and CME on 12 July 12007, the contract traded on the CBOT.

¹⁵ For example, if the average daily federal funds rate over December 2010 was 0.20%, the final price of the December 2010 contract will be 99.80.

¹⁶ Our starting date is due to the fact that the Conference Board index is available beginning at this time.

¹⁷ Results are available on request.

¹⁸ Higher-order serial correlation was also tested for and found to be absent.

¹⁹ We experimented with including lagged values of the macroeconomic variables and found that our results were qualitatively unchanged. The adjusted R ²'s increased somewhat, but the results reported in columns 1 and 2 of Table 2 are unchanged.

²⁰ Our models are estimated under the implicit assumption that the Fed's reaction function is relatively stable over our sample period. Sims and Zha (2006) examine the 1959 to 2003 period and find that across three monetary policy regimes that ‘…stable monetary policy reactions to a changing array of major disturbances generated the historical pattern [of inflation].’ Vazquez (2009) employs a Markov switching model and estimates a reaction function with respect the federal funds rate and finds that such a function is comparatively stable for the 1967 to 2002 period. We thank the referee for this point.

²¹ We thank an anonymous referee for suggesting this.