US Midterm Election Results: Did the economy play a smaller role than expected?

Biggest election issue

The biggest issue by far in the midterms was the economy. Voters were most concerned about inflation, which has been running at a four-decade high. There was widespread resentment across the country with persistently high prices and empty shelves in stores. Food and fuel prices have been rising at near double-digit rates.

On the macroeconomic front, the US GDP contracted in the first two quarters of 2022. The approval ratings for Biden, according to a Reuters/Ipsos poll on the eve of the elections, had crashed to 39%, foretelling what seemed like a massive drubbing.

Implication of results

Does the absence of the angry red wave and better-than-anticipated showing by the Democrats mean the state of the economy matters less than it seemed?

There is no clear explanation why and how Democrats managed to dodge the bullet on the economy. To be sure, across the world, political incumbents of all hues have lost favour with voters in the wake of surging prices brought on by the war in Ukraine.

In some US states, analysts believe, issues such as abortion rights worked to rally Democratic voters. Others argue that thanks to the heavily polarised nature of American democracy, despite resentments, the tribal instinct triumphed, and voters cast ballots along party lines.

Source: Bureau of Economic Analysis

The looming recession

The midterm elections are over — even though full results may not be known for several days from now and Georgia may see a run-off in the Senate race — the economy is unlikely to go off the radar even as the political focus shifts quickly to the presidential election of 2024.

This is mainly because the actions of the US central bank — the Federal Reserve (or Fed) — to control inflation are threatening to push the world’s largest economy into a recession.

Last week, the central bank yet again raised interest rates for the US economy, in line with the aggressive tightening that it has pursued since the beginning of 2022. Higher interest rates slow down the economy by disincentivising consumer spending and making new investments costly. The pace of hikes has been so sharp that it is now almost a foregone conclusion that the US economy will go into a recession — either in 2023 or in the election year of 2024.

Technically, a recession involves the overall output in the US economy contracting in two successive quarters. But broadly speaking, it refers to a prolonged period of economic contraction coupled with job losses, falling incomes and reduced expenditures.

Source: US Bureau of Labour Statistics

Actions of the Fed

Why is the Fed inducing a recession? Simply put, the answer is: to restore price stability in the economy. In a recent statement, Fed Chair Jay Powell underscored the importance of having price stability.

“Price stability is the responsibility of the Federal Reserve and serves as the bedrock of our economy. Without price stability, the economy does not work for anyone. In particular, without price stability, we will not achieve a sustained period of strong labour market conditions that benefit all,” Powell told a press conference.

To be sure, Powell was aware of the consequences of the Fed’s decision: “Reducing inflation is likely to require a sustained period of below-trend growth and some softening of labour market conditions. Restoring price stability is essential to set the stage for achieving maximum employment and stable prices in the longer run. The historical record cautions strongly against prematurely loosening policy. We will stay the course until the job is done.”

The Fed’s target is to get the inflation rate down to 2%; in September it was at 8.2%. The Fed has already raised the interest rate to 4%.

The question is, how will raising interest rates bring down the prices of crude oil and other commodities that are fuelling inflation? In the past, the Fed has accepted that it has no tools to directly bring down prices. But at the same time, Powell has explained why the Fed continues to raise interest rates.

One, unlike many other countries that are simply seeing inflation surge due to supply constraints, the US also has a problem of excessive demand. The US grew very rapidly — a genuine “V-shaped” recovery — as it came out of the pandemic. Higher interest rates tend to tamp down on excessive demand.

Two, by raising rates, the Fed is trying to “keep longer-term inflation expectations anchored and keep the public believing in 2% inflation”. If people stop believing that inflation will, at least in the medium term, come back to the 2% target, they will start asking for higher wages. That will lead to employers (firm owners) raising prices to pay higher wages. This can become a vicious loop.