The Impact of US Midterm Elections on the Federal Reserve and the US Dollar

US Midterm Election Outlook:

• Unless gas prices fall further and US inflation rates fall sharply, the likelihood is that Democrats will lose control of at least the House of Representatives to Republicans.
• The prospect of a gridlock returning to Washington has profound implications for the Federal Reserve and the US Dollar.
• The Federal Reserve could quickly become “the only game in town” again, much like what happened from 2011 to 2016, and again from 2019 to 2020.

Gridlock Back in DC?

In How Record Inflation Will Impact US Midterms, we explored how record inflation could affect the US midterm elections this fall. We concluded that unless gas prices fall further and US inflation rates decline sharply in the coming weeks, the likelihood is that Democrats will lose control of at least the House of Representatives to Republicans, leading to a divided Congress and gridlock back to Washington. .

Such a development will have profound implications for US fiscal and monetary policy for years to come, and will directly impact the American dollarUS stocks, US Treasuries, gold prices, oil prices, and cryptocurrencies. All of these effects will flow through the Federal Reserve, primarily.

Turn Back the Clock

A walk down memory lane is necessary to grasp the potential earthquake coming to American politics – both fiscal and monetary – over the coming months.

In 2010, after former US President Barack Obama and a Democratic majority in the Senate and House of Representatives passed the Affordable Care Act during the Global Financial Crisis, there was a wave of voter backlash across the country. To save the banking system, housing market and auto industry, several rounds of federal government spending were announced to help stimulate the economy.

But the backlash was fierce, as most American households continued to face financial hardship and a weak labor market. The US unemployment rate was still near double digits as the housing market remained in shambles. The 2010 US midterm elections saw Democrats lose control of the House of Representatives. Gridlock has arrived in Washington, as a divided Congress refuses to push through more government spending.

Gridlock was the defining feature of the next few years. Republicans, emboldened by their gains in the 2020 US midterm elections, have called for fiscal austerity to reign in government spending. Bickering ensued, leading to budget sequestration and the US losing its AAA credit rating from Standard & Poor’s in August 2011. By 2014, halfway through former US President Obama’s second term, Democrats lost control of the Senate.

While the federal government was effectively paralyzed by a divided Congress, and then with a Democrat in the White House while Republicans controlled the entire Congress, there was only one game in town to help provide support for the American economy: the Federal Reserve.

Fed Policy During Gridlock

From 2011 to 2016, a paralyzed federal government unable to pass any further stimulus left the Federal Reserve with few options: raise interest rates and snuff out the nascent post-Global Financial Crisis recovery; or keep interest rates near zero and hope that the US economy continued to recover. The Federal Reserve chose the second option:

The period 2011 to 2016 was not the only time of gridlock in Washington in recent years. The same can be said about the period 2019 to 2020 during the sole mandate of former US President Donald Trump. Limited federal government spending until the coronavirus pandemic meant the Federal Reserve had to step back from its interest rate cycle, leading to rate cuts to help buoy asset values. Even as Congress passed its coronavirus stimulus packages, the Federal Reserve cut its key rate again to 0.00-0.25% while resuming asset purchases.

Implications for the American Middle Ages

If the US midterm elections in 2022 deliver a deadlock in Washington – Republicans control only the House or both houses of Congress while a Democrat is in the White House – it means the Federal Reserve will quickly become the only game in town again.

If U.S. inflation rates ease over the next few months, which would have nothing to do with the makeup of Congress, that means the Federal Reserve may move back to prevent a more significant economic downturn, which is already on its radar now that the U.S. economy has contracted for two consecutive quarters.

If the Federal Reserve changes and moves to interest rate reduction, and at the extreme, resumes asset purchases again to encourage investors to change their risk preferences (thereby reducing the return on safer assets, forcing the allocation to riskier, growth-sensitive assets) the effect will probably not be different from what happened from 2011 to 2016 or from 2019 to 2020. Such a change foresees a weaker US dollar; lower US Treasury yields; higher gold prices; higher oil prices; higher cryptocurrency prices; and a float higher from US stock markets.

— Written by Christopher Vecchio, CFA, Chief Strategist