TCS Daily

Rate Hikes Would Help President Bush

By John E. Tamny - April 23, 2004 12:00 AM

Alan Greenspan's belated admission that "deflation is no longer a threat" makes it more certain that he'll increase the Fed Funds rate in the coming months. Those hoping for a Bush victory in November should hope so.

Though it's often assumed that rate increases harm the incumbent in presidential election years, the reality on rates is somewhat more nuanced. History shows that the presumed rate hikes will stimulate the economy in the near-term, while promising a bumpier economic ride over the long-term.

Data compiled by Boston-based economics firm H.C. Wainwright shows that industrial production initially responds positively to rises in interest rates, with growth since 1955 averaging 4.9% when rates jump an average of 171 basis points. While not predicting a specific level of growth, David Malpass appears to agree with the Wainwright view. In recent reports the Bear Stearns chief economist has said he expects a rise in interest rates to "act as an economic accelerant."

But why? The answer isn't really very surprising. Going back to when the Fed began to cut interest rates in December of 2000, a number of economists said that rather than bring rates down gradually, the Fed should do it all at once. Their reasoning was that just as knowledge of future tax cuts can cause economic actors to push activity into the future, so too will telegraphed interest rate cuts cause individuals and businesses to wait to transact/build/invest until the Fed signals rates have hit bottom.

Put simply, why buy a car in the present that will almost certainly be cheaper in the future?

If investors were to be given a signal that rates are to rise sooner rather than later, we should expect the above analogy to come into play again, only this time in the reverse. David Malpass thinks that individuals and businesses will take a "get it while you can" approach to rising rates, and lock in "mortgages, as well as commercial and industrial loans" while rates are still low.

Returning to George W. Bush's re-election prospects, a heightened level of economic activity eight months before the elections should help his chances. What about long-term?

The answer lies in the H.C. Wainwright research that was cited earlier. Wainwright president David Ranson wrote in the Wall Street Journal in 1981 that "loose or tight interest rate policies don't create or destroy GNP outright - they merely reschedule it."

Indeed, while rising rates can certainly stimulate economic activity in the near-term, the Wainwright study shows that this comes at the expense of long-term growth, with industrial production on average plummeting to .9% 18 months after the Fed has finished increasing rates.

The above information should perhaps have Americans a little bit uncomfortable about what lies ahead, but should also make those who think central planning is a bad idea ecstatic. Did it ever make sense that by waving a magic wand 12 "wise men" could create economic growth? It's illogical, and as the Wainwright research makes clear, factually untrue.

Whether readers are happy or unhappy with the present leadership at the Federal Reserve, all should hope that those in charge recognize that there are limits to what they can accomplish. Interest rate machinations geared toward stimulating or shrinking the economy cause economic actors to game the economic system, as they shift economic activity backward or forward depending on the direction of rates.

This is the growth "rescheduling" that Ranson talks about, and is a pretty good definition of the business cycle itself. Assuming an eventual hike in rates is the beginning of a pattern whereby the Fed were to attempt to manage growth through interest rate movements, investors would have reason to be nervous.

Markets don't like economic instability, and returning to the H.C. Wainwright Economics study, economic growth since 1955 has been very uneven when interest rates have moved around a lot. Perhaps unsurprisingly, economic growth is most impressive over the long-term when rates move the least. Here's hoping those in charge at the Fed are aware of the long-term impact of rate movements, and act with the aforementioned impact in mind.


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