After mid-term elections, political headlines shift immediately to a new topic: the next election.
 
Economic issues weren’t the most discussed topics in the 2006 races—war, leadership, values, and scandals got more press. But even in 2006, Americans probably factored their pocketbooks heavily into their vote—and will again in 2008.

The unemployment rate, gasoline prices, the housing market, and taxes all have their impact. But another key issue is interest rates in relation to economic growth—a measurement of the tightness of money, or the difficulty consumers and businesses have in borrowing. When the tightness measure is high—that is, when the Federal funds rate (which banks charge each other to borrow) is more than one percentage point above the nominal growth rate (real GDP plus inflation)—then, my research finds, the chance of a major turnover in political power is elevated.

Most of the major shifts away from the incumbent party in Washington over the last three decades were preceded by high short-term interest rates relative to nominal GDP growth: 1974 (toward Democrats), 1980 (Republicans), 1982 and 1992 (Democrats), and 2000 (Republicans). You can see the wide difference between rates and growth on the chart below. In general, the incumbent party retains power when interest rates are low relative to nominal growth, with two exceptions. In 1976, President Ford was rejected despite interest rates well below nominal growth. Ford had ascended to the White House after President Nixon’s resignation and had then pardoned Nixon—an unpopular move at the time. Also hurting Ford’s chances was the fact that the sharp 1974 tightness was probably still running its course. And in 1994, the incumbent Democrats lost 54 seats despite low interest rates relative to growth. This was perhaps because of the Contract with America and health care tensions—remember the effective attack on Hillary-care—but was also caused by the unusually high number of freshman congressmen up for reelection (1992 had brought 110 new congressmen to Washington, the highest entry since 1948).

Right now, many analysts think we’re in a slowdown, creating the possibility of rate cuts in 2007 and a recovery in 2008. This is a Goldilocks scenario for the economy, the Federal Reserve, and Republicans. A less favorable scenario is that core inflation goes higher, growth continues, the Fed pushes interest rates up rather than down, and the economy slows later than the consensus view now expects. In my view, this latter outcome is increasingly likely, creating the prospect of a major political swing away from Republicans in 2008.

 The issues in previous swing elections varied substantially, but monetary tightness was a common thread. In 1974, with Gerald Ford completing the sixth year of Republican presidency, the Democrats picked up 48 seats in the House and five in the Senate. Watergate, Vietnam, inflation, and oil prices all mattered. But so did the gap between interest rates and growth. The average Fed funds rate in the third quarter was 12.1 percent while year-over-year nominal GDP growth in the period was 8.8 percent—a gap of more than three percentage points.

The big question now is how much tightness there will be before the 2008 election.

A hostage crisis and high gasoline prices influenced the 1980 election, but the backdrop was an average Fed funds rate in the second quarter of more than 12 percent versus nominal growth of 8 percent. The tightness got even worse by the fourth quarter as Paul Volcker, the Fed chairman, continued using high rates to combat inflation—15.9 percent interest rates topped the 9.6 percent nominal growth rate by more than six points. The incumbent Democrats lost the presidency, the Senate, and 35 House seats in 1980. With money tight again in 1982, Republicans lost 26 House seats.

President George H. W. Bush blamed high interest rates, at least in part, for his loss in 1992. Bush agreed in 1990 to raise taxes, breaking his campaign pledge. At the time, he believed that the Fed would cut rates deeply that year, rather than waiting until 1991. Instead, the gap between rates and growth grew, peaking in 1991—earlier than in other swing elections but still significant enough to affect the outcome.

The controversial 2000 election provides a clearer interest-rate story. Nominal growth was slowing sharply in 2000, partly because of deflationary pressures related to the strong-dollar policy. The Fed recognized the slowdown risk in January 2001 with an interest rate cut to 6.25 percent, but the Fed funds rate had been well above the nominal growth rate in the run-up to the November 2000 election. At peak tightness in the fourth quarter of 2000, the Fed funds rate was 6.5 percent while nominal growth was 4.6 percent year-over-year.

The blunter notion that “it’s the economy, stupid” didn’t really work in 2000. The recession didn’t start until April 2001 and wasn’t announced as a recession until November 2001. The stock market and corporate profits had been weakening through 2000, but unemployment was still below 4 percent in November 2000. The monetary tightness in 2000, plus the problem of high gasoline prices, provides more insight into the result than the “economy” in the abstract.

This year, the gap between interest rates, which averaged 4.9 percent in the second quarter, and nominal growth, at 6.9 percent, was definitely incumbent-friendly. Other factors also determine election outcomes, but the tightness measure is generally ignored, even though it plays a key role.

The big question now is how much tightness there will be before the 2008 election. This far in advance, it’s a crystal ball game. The current consensus assumes a near-term hard or soft landing. According to this projection, inflation will moderate and consumer spending will slow because of previous interest rate increases and the soft housing market. But through October, consumption growth has been relatively solid, probably because of continued low unemployment, low real interest rates, and rising incomes. This reality suggests a different 2008 scenario: what if inflation rises, rate hikes resume, and economic growth slows in the second half of 2007 and into 2008, a “late landing”?

The tax situation presents an important pocketbook difference between the 2008 election and previous ones. A huge tax increase is locked into law for 2011, returning many tax rates on income, dividends, and capital gains to pre-2003 levels.

 Inflation is a key variable in the outlook for 2008. Declining energy prices will reduce the overall Consumer Price Index inflation rate for September and October 2006. Inflation had bulged to 4.7 percent in 2005, and an unwinding was due a year after Katrina. Core inflation (without energy and food) has been rising and may continue higher in coming months, approaching 3 percent. Rents are an important contributor and seem to be headed up because of rising costs and high occupancy rates.

If core inflation does rise, the Fed would probably choose to push interest rates higher, especially if consumption keeps growing, housing starts stabilizing, or the unemployment rate falls even lower. The Fed funds rate could become elevated, perhaps 6 percent (it is now 5.25 percent), for several quarters in 2007 unless core inflation, primarily the rent component, moderates. Nominal growth might slow to 4.5 percent—it bottomed at 4 percent in the 1995 mid-cycle slowdown and at 2.7 percent in the 2001 recession.

Subtracting growth from the interest rate, the result could be an incumbent-unfriendly 1.5 percent tightness reading prior to the 2008 election. This possibility bears a loose resemblance to the 1992 election: monetary tightness relative to growth peaked in the first quarter of 1991, when the Fed funds rate averaged 6.4 percent and year-over-year nominal growth fell to 3 percent. If there’s a late landing in 2007, the peak of the tightness would be closer to the election than it was in 1992.

The tax situation presents an important pocketbook difference between the 2008 election and previous ones. A huge tax increase is locked into law for 2011, returning many tax rates on income, dividends, and capital gains to pre-2003 levels. Congress’s current fiscal scoring system ignores the impact on growth of tax changes, so legislation to delay or repeal the 2011 tax hike will appear unattractive since it would be scored as a multitrillion tax cut, assumed to push up the budget deficit. But the scoring system ignores the impact on tax receipts of an economic slowdown triggered by tax increases.

What complicates the pocketbook analysis for 2008 is that the prospect of a big tax increase in 2011 could be a burden on 2008 growth and investment, contributing to any slowdown already underway and widening the interest rate/growth gap.
 
The chain of possibilities shows an elevated chance of a swing in political power in 2008 toward the Democrats. Rising core inflation in 2006 and continued economic growth could cause higher interest rates in 2007 and an economic slowdown, poorly timed for the 2008 election. The prospect of a swing away from the Republicans increases the chance of a 2011 increase in tax rates. The Fed will undoubtedly maintain its political independence, as it did during the years when Alan Greenspan was at the helm, and stick to the knitting. It will focus on inflation and not on the distant prospect of a contraction brought on by a tax hike in 2011.

Certainly, other election-year issues will play a role, but if we end up with high interest rates and slower nominal GDP growth, the Republican candidate will face an uphill battle to election.

David Malpass is chief economist of Bear Stearns. He held posts in the Treasury and State departments of the Reagan and George H. W. Bush administrationsand was Republican staff director of the Joint Economic Committee of Congress.

 Subscribe to The American