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The Future of the Fed

Former Fed Governor Janet L. Yellen points out that Greenspan could have used his influence to get that point across as well. After he was attacked for warning of the dangers of irrational exuberance in 1996, he mostly stayed away from the topic. "I wish he had continued to talk about it," says Yellen. For his part, Greenspan doubts public jawboning is useful unless it's backed up by higher interest rates.

Privately, associates say that Greenspan's objection to reining in the runaway stock market was political as well as economic. He thought the central bank lacked the mandate to act, and he worried that raising rates to restrain the bubble could have caused a political backlash that compromised the Fed's cherished independence.

History, however, shows that the Fed's mandate evolves over time. For example, the emphasis on inflation fighting--which today is integral to the Fed's mission--didn't take hold until soaring prices and a falling dollar forced President Jimmy Carter to appoint Paul A. Volcker as Fed chairman in 1979.

Similarly, the events of recent years are pushing Greenspan to take more account of financial markets. He realizes that as wealth rises faster than income--as it has over the past 20 years--the asset side of the nation's balance sheet becomes more important.

The wild card in the debate over the future of the Fed, of course, is what happens in the next couple of years. If the U.S. economy and stock market bounce back quickly, Greenspan and his forward-looking approach will look a lot better. If today's slump continues, the next Fed chairman will be tempted to do something rather different.

There's a third possibility: If the economy stalls and fears of deflation increase, the Fed will feel pressed to rev up short-term growth by any means available. The danger: If prices and incomes start falling, the financial system could seize up. Borrowers would find it harder to pay back debts, and banks would be unwilling to lend money at near-zero interest rates. Moreover, the Fed's usual policy tools for boosting growth would become less effective. Typically, the Fed combats recessions by trying to create so-called negative real interest rates--rates below the level of inflation--to induce skittish consumers and companies to borrow and spend more. But if inflation is negative, that strategy won't work, and the economy could fall into a downward spiral.

The prospect of deflation has already altered the attitudes of anti-inflation hawks such as Richmond (Va.) Federal Reserve President J. Alfred Broaddus. "I've spent most of my career focused on reducing inflation," he said in a speech earlier this year. "[But now] I've become more conscious of the kinds of policy problems that can arise in a low-inflation, low-interest-rate environment, especially when the economy softens."

Still, Fed policymakers are confident--cautiously so--that the U.S. can avoid the fate of Japan, which seems stuck in a deflationary trap. Greenspan, for one, believes that a lot of Japan's problems are cultural and structural. In a society that prizes consensus, Japanese authorities have not taken the tough steps needed to overhaul the country's banking sector.

Moreover, should deflation hit and U.S. short-term interest rates fall to near zero, Greenspan and other members of the Fed have said that they are ready to take unconventional policy measures. "There's a general view that as the federal funds rate gets to zero, we are out of business," Greenspan told the Council on Foreign Relations on November 19. "That is not the case." Among the potential strategies: buying long-term bonds to drive long-term interest rates down and purchasing foreign currencies to lower the dollar's value. In theory, such measures could stimulate growth: For example, a lower dollar should boost exports. But in practice, the Fed has far less control over long-term interest and exchange rates than it does over short-term interest rates.

Another concern, both inside and outside the Fed, is the value of the dollar. Some Fed officials suspect the dollar is overvalued: They liken it to the pre-crash stock market. They worry that the dollar-driven trade deficit is unsustainable in the long run and will eventually lead to a disruptive plunge in the dollar. But Greenspan and his supporters don't see what they can do about the dollar's value, short of driving the economy into recession and drastically reducing America's demand for imports. So they've adopted the same approach that they used for stocks: Wait--and be prepared to act quickly to limit economic fallout should the dollar suddenly collapse.

In the end, Greenspan's legacy will be judged by how the economy does in the next couple of years. A weak performance will tarnish the gains of the 1990s and cause people to back away from Greenspan's strategy of a flexible monetary policy and his espousal of a high-growth, high-risk economy. But if growth picks up and the stock market recovers, which many economists expect, then Greenspan's vision of the future will prevail--and the chairman would go down in history as the best central banker ever.

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