The Federal Reserve May Be Politically ... - Pluto Huji Ac Il

πE + bπED) ought to be positive). It is easy to see that in Table 3 the sum of the
coefficients for Election × π and Democrat × Election × π is positive.
Figure 5 plots equations 2 and 3 along with 95% condence intervals for the four
equations in Table 3 - which differ only in the measure for ination used. e positive
slopes on the gray lines suggest that, as the election approaches, the Fed becomes
an ination hawk if a Democrat is in office. e negative slope on the black lines
suggest that the association between interest rates and ination converges to zero as
Republican incumbents near re-election. e slope parameters in 2 and 3 will differ
by the value of the Democrat × Election × π coefficient in Table 3. Note that this
is consistently positive and statistically signicant except where the Cleveland Fed’s
measure of expected ination is used.
Some details depend on the measure of ination used. When ination or expected
ination based on household survey are used, there is a signicant and positive
relationship between ination and interest rates in the later portion of a Democratic
administration. is is not the case under Republicans. 7 When either the survey
of nancial professionals or the Cleveland Fed’s model-based variable are used to
measure expected ination, there is a statistically signicant link between ination
and interest rates only when Democrats control the White House. Whichever set
of measures are used, the Fed appears to be a conditional ination hawk. e top
panels of Figure 5 suggest that the Fed turns off its responsiveness to ination when
Republicans are facing re-election, and turns on its responsivenss to ination when
Democrats are facing re-election. e bottom panels suggest that the Fed places little
or no weight on hitting its ination target when Republicans are in office, but is quite
sensitive to ination when Democrats are in office - especially as elections approach.
Our model also makes conditional statements about the relationship between interest
rates and the output gap, but the modifying effect of party operates differently.
When the Fed acts as an ination hawk it places less weight on hitting its ination
target. Under such conditions, we expect the Fed to be relatively insensitive to the
output gap as it shis its attention toward ination. Consequently we should observe
a weakening of the relationship between interest rates and the output gap when
Democrats are in office and the election draws near. Conversely, the Fed should react
strongly to the output gap when elections approach and the incumbent is Republican.
Figure 8 reports lines analogous to equations 2 and 3 for the effect of the output
gap on interest rates along with 95% condence intervals. e black lines show that,
regardless of how ination is measured, interest rates are positively associated with
the output gap in pre-electoral periods. e coefficient on Election×Y gap in Table 3
7 Conversely, there is a signicant and positive relationship between ination and interest rates in
the post electoral period only when Republicans are in office. is is consistent with the idea that the
Fed deliberately contracts the economy early in a Republican administration so that the economy will
bounce back in time for elections.
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