One of the biggest questions facing financial markets and the global economy this year – perhaps the biggest question – concerns what will happen to monetary policy in America. Will Alan Greenspan and the other members of the Federal Reserve’s open market committee (the FOMC) raise interest rates this year, ahead of George W. Bush going head-to-head with John Kerry in the presidential election in November?

Out of this question spring others. If rates go up, by how much? If they do not, will this mean storing up big problems for the future, and that the eventual post-election rise would need to be even bigger? And what would higher rates mean for the dollar, in other words to what extent has dollar weakness been driven by ultra-low US rates, and to what extent by other factors?

Looked at from this side of the Atlantic, a 1% level of official interest rates in America looks absurdly low. The economy, after all, is growing at an annualised rate of at least 4%, even if it has not quite maintained the 8.2% pace of expansion achieved in the third quarter of last year. Such a low level of interest rates might be appropriate for a stagnant economy but surely they cannot be right for one that is booming.

Not only that, but to have such low interest rates alongside a falling currency appears to be a recipe for disaster. Faced with a similar combination of circumstances can anybody imagine the Bank of England’s monetary policy committee standing idly by?

It looks on the face of it highly political. The Fed, on this interpretation, would be raising interest rates but is constrained from doing so for fear of scuppering the president’s re-election hopes. This is not even to suggest that the independent Fed is being politically partisan, merely that the central bank is heavily constrained from acting in such a highly charged political atmosphere.

It is not, however, quite as clear-cut as that. US inflation, despite the dollar’s weakness, is remarkably benign, with core inflation running at just 1.1% at time of writing and expected to edge down further in the coming months. Not only that but in the views of some experts America still has to be on its guard against deflation. Ben Bernanke, the influential Fed governor, has said – unusually for a central banker – that there is such a thing as too low an inflation rate and that the United States is probably in this position at present.

There are other economic arguments for very low interest rates. While the growth numbers look spectacular, the US job market has appeared stagnant, and the “jobless recovery” a reality. Month after month the increase in employment (non-farm payroll jobs) has come in below expectations. The verdict of the official Bureau of Labour Statistics is that overall employment has been broadly stuck for the past 18 months which, alongside rising population, means an increase in economic inactivity.

Some economists cite other evidence, such as household survey data, which points to a stronger jobs market. That, however, is a minority view. The majority view is that the job market is too weak for a Fed chairman (Greenspan) worried about potential inflation, or for that matter for a president concerned about re-election.

There is another argument for low interest rates, which has much to do with Greenspan’s view of his own legacy. Having been blamed for accepting the technologically-driven “new” economy too readily in the 1990s, and for having allowed the stock market bubble to build and then burst, he has a great personal interest in seeing both the economy and the markets fully rehabilitated. And if this means a bias towards growth and away from an overly anti-inflation stance, so be it.

All that said, for Greenspan, as for every previous Fed chairman, politics does come into it. How much is he constrained from raising rates in an election year? Analysts at 4Cast, the economic consultancy, have performed a useful service by tracing back the actions of the Fed during previous presidential election years.

If we go back to the 1970s, there appears to have been a clear moratorium on pre-election rate rises. Arthur Burns, the legendary Fed chairman, kept rates steady ahead of Richard Nixon’s election but then raised them sharply afterwards. In 1976 rates were on hold all year, and for several months after the election.

This pattern changed dramatically in 1980. The Fed tightened in October, a fortnight before Jimmy Carter lost to Ronald Reagan. In 1984, Reagan’s re-election year, the Fed was raising rates up until August but then switched to cutting them, the last pre-election reduction coming in October, but continuing afterwards. A similar thing happened in 1988, when George Bush senior succeeded Reagan. This time, however, the Fed was raising rates until August then stopped doing so, but recommenced two weeks after the election.

Bush senior’s re-election attempt in 1992 gave us what 4Cast describes as “arguably the most politically charged period of Fed/White House relations in modern history”. Rates were falling in 1991 and 1992 but not by enough for Bush’s liking. Concerned about the jobless recovery he publicly urged the Fed to be much more aggressive, and made little secret of his unhappiness with Greenspan, either before or after the election. “I reappointed him; he disappointed me,” Bush later said.

There were no such problems for Bill Clinton and Greenspan in 1996, rates being held steady through election year, or in 2000, when the Fed was raising rates until May but then refrained from further hikes, although Al Gore, the narrowly defeated Democrat candidate, might have hoped that the Fed, which began cutting rates in January 2001, had done so a little sooner.

So what does this tell us about US rates for the remainder of this year? History tells us that rate moves immediately before presidential elections are rare but not unprecedented. It also tells us that, for preference, the Fed prefers to get rate changes out of the way some months before voters go to the polls.

Honour would be served this time if rates edged higher over the summer, perhaps by no more than half a point in all, and then were held until next year. The two pivotal FOMC meetings thus become those on June 30 and August 10. The odds are on a small upward move at one or both of those meetings. But do not expect anything too dramatic. Good central bankers, after all, are also good politicians.

From Professional Investor, May 2004