Do politics cause regime shifts in monetary policy

TL;DR: In this paper, the authors examine the link between politics and regime shifts in monetary policy using two alternative.approaches and conclude that both the presidential and Federal Reserve Bank (Fed) chairmanship regimes do not influence monetary policy under the assumption that the Fed closely follows an interest rate rule.

Abstract: Whether or not politics cause changes in monetary policy is controversial in the literature. This article re-examines the link between politics and regime shifts in monetary policy using two alternative .approaches. First, empirical results show that both the presidential and Federal Reserve Bank (Fed) chairmanship regimes do not influence monetary policy under the assumption that the Fed closely follows an interest rate rule. On the other hand, evidence also suggests that changes in political regimes are able to account for the deviations from the optimal Taylor rule (JEL E52, E58, D78) I. INTRODUCTION This article empirically investigates whether politics cause regime shifts in monetary policy. Many studies have shown evidence that there are regime changes in U.S. monetary policy when short-run interest rates are used as a policy measure. For instance, see Huizinga and Mishkin (1986), Perron (1990), Garcia and Perron (1996), Bai and Perron (2003), and Duffy and Engle-Warnick (2006). (1) However, it is still unclear what factors account for the policy regime changes. In particular, whether political regime changes may cause such regime shifts in monetary policy has been controversial in the literature. As the conventional wisdom holds that the independence of the Federal Reserve System insulates them from political pressures, some early studies have found evidence for an electoral cycle pattern in monetary policy. Hibbs (1977, 1986) investigates the role of partisan politics for macroeconomic policies, and emphasizes the systematic differences in macroeconomic policymaking between the unemployment averse and the inflation averse. Beck (1982, 1987) uses several measures of monetary policy stances such as money aggregates, nonborrowed reserves, and the federal funds rate to estimate reaction functions, and finds no evidence of a politically induced cycle in monetary policy. Finally, regarding the monetary policy decisions of the Federal Open Market Committee (FOMC) over the period 1960-1998. Pierce and Rebeck (2001) show that nonmacroeconomic variables such as political factors receive little attention unless macroeconomic conditions are difficult for policy makers to assess. In contrast, Grier (1987) finds a regular cycle in money growth corresponding with presidential elections, and Hakes (1990) makes a prominent contribution to show strong evidence that the intentions of monetary policy are significantly different among the Martin, Burns, and Volcker chairmanships. From a different perspective, a series of studies by Caporale and Grier (2000, 2005a) use political dummy variables to make a thorough investigation, and find evidence that structural breaks in U.S. real interest rates are consistent with changes in political regimes such as in the party of the presidency or in the chair of the Federal Reserve Bank (Fed). They argue that the evidence indicates a significant influence of politics on monetary policy. However. Rapach and Wohar (2005) propose an alternative explanation: that the regime shifts in real interest rates may be attributed to breaks in inflation. They find that the dates when inflation and real interest rate regime change occur are very close. To reconcile these two hypotheses, Caporale and Grier (2005b) have attempted to control for the timing of changes in the inflation regime. They show that even when inflation regime shifts are controlled for, political dummy variables remain strongly significant in explaining real interest rate fluctuations. It is not an easy task to distinguish the more plausible explanation under the structural break models implemented by Caporale and Grier (2000, 2005a, 2005b) and Rapach and Wohar (2005). As noted by Rapach and Wohar, ... our empirical approach in the present paper does not explicitly identify the underlying economic structure, and we thus cannot conclude on the basis of our structural break tests alone that breaks in real interest rates are primarily a monetary phenomenon. …