Where the magic happens. (Andrew Harrer/Bloomberg)
A common rule of thumb among economists is that left-wing governments pursue polices that lower unemployment but cause inflation. Right-wing governments are expected to fight inflation even at the cost of higher unemployment. Recent experiences suggest that this rule isn’t all that accurate. There actually isn’t much difference in economic policies under left and right-wing governments. So what then are the consequences of monetary policy-makers sticking to this rule of thumb? In a recent article (gated, ungated) we investigated this question by looking at the United States Federal Reserves’ inflation forecasts.
Monetary policy-making is inherently forward-looking. Interest rates are set with expectations of future inflation in mind. In pursuit of price stability, modern central banks aim for moderate inflation. In many places the goal is 2 percent. Crudely, if central bankers think that inflation will be too high, then they raise interest rates to tamp it down. This tends to also slow economic growth and employment. Central bankers can respond to inflation that is too low by lowering interest rates. This tends to also increase economic growth and employment.
When inflation is overestimated, central bankers may implement monetary policies that inappropriately slow growth. On the other hand, when inflation is underestimated, policies may fuel economic growth and possibly future bubbles. Expectations about inflation thus have an important impact on our everyday lives.
To see how accurate inflation expectations are, we looked at about 40 years of forecasts made by the United States Federal Reserve. We found that, regardless of what economic policies were pursued, the Fed tended to overestimate inflation when the president was a Democrat and underestimate inflation for Republicans.
The figure below shows our predictions about the forecasting errors that the Fed makes when the president is a Democrat (blue bars) compared to when he is a Republican (red bars). We accounted for a variety of economic and policy conditions, including government expenditures, interest rate changes, unemployment and recessions.
Graph by Christopher Gandrud and Cassandra Grafström
The lines move closer to zero—a perfect forecast—as the forecast period nears. This means that later forecasts tend to be more accurate. Nonetheless, even for the present quarter there are still distinct differences based on the partisanship of the president. Inflation in the present quarter tends to be underestimated by about 10 percent when the president is a Republican and overestimated by about 15 percent when he is a Democrat.
Not only do Fed forecasters anticipate that Democratic presidents will have a bigger impact on inflation than they actually do, but forecasters also expect government spending to increase inflation more than it does. And these overestimates for Democratic presidents and government spending are related.
The partisan rule of thumb says that left-wing parties, pursuing lower unemployment, cause higher inflation by trying to boost the economy with government spending. More government spending increases the supply of money in the economy and so the value of money goes down—thereby creating inflation. The problem is that this scenario occurs less often than the Fed expects.
Here’s why this matters for politics. This incorrect rule of thumb could lead the Fed to raise or lower interest rates at inappropriate times. For Democratic administrations they may keep interest rates too high, constricting growth. And for Republican administrations they could keep interest rates too low, fueling economic growth in the short to medium-term, but possibly causing bubbles in the future. Neither of these outcomes is desirable from an economic standpoint.
What’s more, we know that economic well-being is strongly related with voters’ choices. If the economy is doing well, incumbents are more likely to be reelected. When it is doing poorly they are more likely to be kicked out. Using this incorrect rule of thumb to predict inflation could lead to monetary policies that unfairly handicap Democrats in elections and give a boost to Republicans.
Christopher Gandrud is a Post-Doctoral Researcher at the Fiscal Governance Centre, Hertie School of Governance. Cassandra Grafström is a PhD candidate at the University of Michigan.