Iran war

This is my last post before the midterms Tuesday. What will they bring?

Midterm elections are usually bad for the President’s party:

I don’t think this year will be an exception to the rule. I see many indicators pointing in the same direction.

The largest US prediction market Kalshi currently gives Democrats a 91% chance to take the House and a 66% chance to take the Senate. The international Polymarket and play-money Manifold currently give slightly higher chances, 93/67 and 94/69. Forecaster Nate Silver is higher still at 95/76.

The best odds I’m seeing for Republicans among the models I have followed for years is Ray Fair giving Dems only a 60% chance to take the House (he doesn’t forecast the Senate). In Fair’s model, the economy is working in favor of Republicans; inflation is a negative for them but economic growth is a stronger positive (including the 3.4% Q3 GDP estimate just released today).

In practice though I think economic issues are working in favor of Democrats. The economy is good in many ways, like 4.2% unemployment- but most people aren’t happy about it. Consumer sentiment is at record lows. Economic growth is solid but largely driven by the AI boom, which gives people plenty to be nervous about. Inflation is only a bit high (3.4% vs a 2% target) but easy to tie to administration policies like tariffs, war, and pressuring the Fed to lower interest rates. Ad spending indicates that politicians on both sides think tariffs have gone from a minor issue that voters have mixed feelings about to a major issue that voters don’t like:

Gas prices have long been especially salient, and are currently high because of the Iran war. I said here in March:

if the US administration wants to avoid a midterm wipeout driven by high gas prices, I see only 3 options:

Get lucky and see the Iranian regime fall quickly

Negotiate an end to the war quickly (which might itself be unpopular if they can’t get a good deal) or just declare victory and go home (but its not clear whether Iran would re-open the strait now just because the US stopped bombing)

Restrict Exports

But they took none of those three options, and now it seems the midterm wipeout is coming.

I predicted a ‘moderate red wave’ here in 2022. I predict a blue wave for 2026 that is bigger than the red wave of 2022, though not a ‘mega tsunami‘. The main things Republicans have going for them are the Senate map (Dems need to win in multiple 2024 red states to win) and the possibility that angry anti-incumbent voters will take down some Dems too.

Next week the Fed will almost certainly hold interest rates steady. Stephen Miran will probably dissent saying the Fed should be cutting rates. Kevin Warsh, Trump’s nominee for Fed Chair, would also like to see cuts. But other prominent voices think that rising oil and gas prices mean we should be raising rates.

I still think that rate hikes make more sense than cuts- but not because of oil. The high oil and gas prices we’re seeing are obviously driven by supply shocks from the Iran war- not increasing demand. Raising rates to fight an oil shock would mean repeating a classic mistake.

But raising rates to fight core inflation that is at 3% makes perfect sense. Especially when inflation (overall or core) hasn’t been at or below the Fed’s supposed 2.0% target in over 5 years, and market forecasts predict it will stay well above 2.0% for the next 5 years.

Especially when real GDP is growing, and NGDP is still above trend, and the unemployment rate is 4.3%. Financial conditions are so loose that stock markets are hitting all time highs in the middle of a war.

Various Taylor Rules suggest that the Fed Funds rate should be between 4.25% and 6.25%, but the Fed currently has us at 3.75%.

I see so many good arguments to raise rates- there is no reason to bring up a bad one like oil prices. If we must latch on to a headline to find the argument to raise rates, let’s focus on a shoe company’s stock going up 600% because they announced they were pivoting AI.