Greenspan and Elections: The Spread Between the Fed Funds Rate and the Taylor Rule Rate

In previous posts, I indicated that going back to 1959, on average we observe patterns in the Fed Funds rate, real M1 per capita, real M2 per capita, and even the 10 year bond rate that we would only expect to see if we were paranoid and thought the Fed was trying to influence elections. Furthermore, this pattern of funny behavior became funnier during the Greenspan era.

Several readers have indicated that perhaps this behavior is tied to Fed policy, and that the Fed is simply following the Taylor rule. My impression, since grad school, is that the Taylor rule is one of those irrelevancies that people talk about as if its important but which doesn’t affect policy at all. But, I could be wrong, and we aim to please at Angry Bear, so here goes…

The Taylor rule, supposedly, is a rule that the Fed uses (or should use or maybe perhaps kinda sorta uses, or whatever) to determine what the Fed Funds rate “should be.”

The basic rule is:

Taylor Rule Fed Funds rate = 0.04 + 1.5(inflation -0.02)
+ .5(ln(GDP) – ln(potential GDP))

Why inflation less 0.02? Well, supposedly the Fed should (or does or kinda does) target a 2% inflation rate. Now, I understand the GDP deflator is generally used to correct for inflation, but I figure that results should be the same using inflation computed using CPI, and since I already had CPI handy, that’s the approach I took. I can’t see how it would make a systematic difference.

Real potential GDP is available from the St. Louis fed. The data is available for January, April, July and October. This is a bit off from the real GDP figures, which are available March, June, September and December. I assumed that it would be OK to subtract one series from the other – while errors might exist, I assumed there wouldn’t be systematically different from one period to the next.

OK. Now, before going on, what might we expect to see? In my case – recall what I’ve stated in several posts. My belief is that during the Greenspan years, in 1988, the Fed did nothing to influence the election. However, I think that in 1992, 1996, and 2000, the Fed did try to influence elections, but by moving real M1 per capita. (Since the quarterly correlation between the fed funds rate and the percentage change in real M1 per capita is about negative .28 going back to 1959, moving real M1 per capita will not necessarily require a move in the fed funds rate.) Finally, I stated several times that I think the Fed tried to influence the 2004 election by dropping the fed funds rate.

Now, if I’m right, that means in 2004, we should see the Fed Funds rate drop relative to the Taylor Rule rate. This despite the fact that the Fed Funds rate was already relatively low as a result of the massive rate cuts in the early years of the GW administration. In fact, because the Fed probably believes it takes a few months for the Fed Funds rate to have an effect on the economy, I would expect the biggest difference between the Fed Funds rate and the Taylor rate to occur a few months (between 3 and 9, perhaps?) before the November election. In fact, I wouldn’t be surprised if that proved to be the biggest spread between the two series in the entire Greenspan era, again, despite the big drops after 2001.

Someone more rational, who knows Greenspan wouldn’t do such a thing, would say something different. Given the reductions in the Fed Funds rate in 2001 – 2003, and the fact that the economy was picking up by 2004 (remember – the administration still hasn’t stoped bragging about the economy’s behavior since the 2003 round of tax cuts), such a person would assume the FF would be more than the Taylor rule rate, or at the very least, the gap between the real fed funds rate and the Taylor rule rate would be narrowing by 2004.

So what do we see?

The table below shows the 4th quarter Fed Funds rate less Taylor rule rate for each of the Greenspan years.

Hmmm… turns out that the spread did indeed widen in November 2004 relative to other Novembers. One crazy-assed cynical prediction borne out. What about in the year leading up to 2004 elections? Well, it turns out that in Q2 of 2004, fed funds less the Taylor rule was -.043. In absolute terms, this was the biggest spread between the two series in Greenspan’s entire tenure as Fed Chair. So another crazy-assed cynical prediction borne out. Granted, this is only one election… so no doubt its just a coincidence, but this is about the 14th or 15th post I’ve written on the Fed’s behavior around election time, and in each post, I’ve shown a coincidence or three. So chalk this one up as another random coincidence.

Fed Funds Rate
Monthly CPI
Quarterly real GDP per capita


As always, let me know if you want my spreadsheet.