The New Fed
COVER STORY PODCAST
Welcome to the era of the diminished Fed. For more than 25 years, Main Street and Wall Street have stood in awe of America's central bankers, the mythic figures who chaired the Federal Reserve. Paul A. Volcker, Fed chairman from 1979 to 1987, battled the dragon of double-digit inflation, besting it at the cost of a deep recession. Alan Greenspan, in turn, was lauded for his rapid response to the stock market crash of October, 1987, shortly after taking office as chairman. Later he fought off the effects of the Asian financial crisis of 1997 and dampened the damage from the tech bust and the terrorist attacks of September 11. Not for nothing was he called the second-most powerful man in the world.
The Fed itself was far more powerful than any other central bank. Interest rates around the world followed its lead. Backed by the dominance of the U.S. economy, the Fed was able to flood the world with dollars when financial disaster threatened. And the institution's influence was magnified by the attention and respect given its leader.
But the time of the heroic central banker and the all-powerful central bank is coming to an end. If the incoming Fed chairman, Ben S. Bernanke, has his way, monetary policy will depend much less on the force of will, keen economic insights, and other exceptional qualities of the Fed's chief. Instead, Bernanke will move the Fed toward clear and coherent rules for hitting publicly announced inflation targets -- an operating style that he calls "constrained discretion."
At the same time, the increased importance of international financial flows will make it much harder for the Fed to have the clout, both at home and abroad, that it once did. In particular, the dependence of America on foreign investors to fund its massive trade deficit puts the country in a far weaker financial position. "That's the big difference from when Greenspan took over," says Robert Hormats, vice-chairman of Goldman Sachs International Corp. (GS )
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"DEPERSONALIZING" MONETARY POLICY
So both out of choice and out of necessity, Bernanke is going to preside over a diminished Fed. In fact, he's one of a worldwide group of top monetary economists who have concluded that the right thing to do is to shrink the scope of central banks everywhere and get them back to their mission of fighting inflation. "Having the central bank get into issues that really are not issues of the central bank is a mistake," says Columbia University Graduate School of Business professor Frederic Mishkin, a former senior official at the New York Fed and a co-author with Bernanke of some seminal articles on inflation targeting. And depending on rules -- not the insights of individual policymakers -- will produce better results, he adds. "Depersonalization of monetary policy is a good thing."
In many ways, the urge to reduce the discretion of the Fed, although shared by economists of differing political persuasions, is broadly analogous to the conservative drive to limit the activism of judges. In both cases, advocates see the same advantages: more predictability and less uncertainty. Not surprisingly, the choice of Bernanke is strongly supported by conservative icon and Nobel Prize winner Milton Friedman. "I think he's an able man who has the right view about monetary policy," Friedman told BusinessWeek. "The worst thing you can have is a free-ranging Fed."
Of course, the Fed under Bernanke will still have all of its vast powers -- the ability to print dollars at will, regulatory clout over banks, and control over short-term interest rates. The Federal Reserve building will still be a massive landmark in Washington. And the Federal Reserve Bank in New York, not far from the site of the World Trade Center, will still house the world's largest accumulation of gold, much of it stored for foreign governments.
Bernanke may also find that his vows of self-restraint will be more difficult to keep once he's sitting in the chairman's spot at the big conference table. If he's faced with a fast-developing financial crisis -- like Greenspan was in 1987 when the stock market crashed two months after he took office -- Bernanke may find himself forced to take an activist role. "Monetary policy is always going to be central, and the ability to sustain global confidence will be even more important in the future than it has been in the past," says Lawrence H. Summers, president of Harvard University and Treasury Secretary under President Bill Clinton. "Much of that responsibility [to maintain confidence] rides with the Fed."
Still, at least at first, Bernanke will cut a smaller figure on the national and global stage. He is one of the top economists of his generation, and he has a wry, self-deprecating wit, frequently directed at his unfashionable clothing. He's also known as a good listener and consensus builder. However, he doesn't have the depth of Washington experience that Greenspan had upon taking office. Nor does he have Greenspan's extensive Wall Street or corporate ties. That means Bernanke, 51, lacks the sort of innate feel for the rhythms of the financial markets and business that only comes with experience. Moreover, as an academic he concentrated his research on monetary policy and did not stray into more partisan fields such as entitlements spending and tax cuts. He'll try to keep that single-minded focus at the central bank. That could undercut his influence in the capital, long used to Greenspan's penchant for commenting on anything economic.
Even if Bernanke wanted to become a heroic central banker, he will find that the financial markets no longer respond so well. For the past 16 months, the Fed has relentlessly raised the overnight interest rate that it controls, which in the past would have pushed up long rates and slowed the economy. Yet rates on 10-year Treasury notes are largely unchanged, suggesting that the flow of funds into the U.S. from China, Japan, and Europe is overwhelming the Fed's actions.
LESS SHOOTING FROM THE HIP?
The new chairman may also feel constrained in the area of crisis fighting, a key priority for the Fed. In past crises, Greenspan could act independently, backed by the most powerful central bank in the world. But now, with nearly half of U.S. government debt held overseas, Bernanke may be forced to seek help from foreign central banks, among the biggest investors in U.S. Treasury securities, in managing a crisis.
Meanwhile, Bernanke's commitment to public inflation goals is likely to slow the Fed's adjustment to sudden and unexpected changes in the economy. Take the productivity surge which began in 1996 and 1997. Back then, most forecasting models were predicting inflation would accelerate. That would have led an inflation-targeting Fed to boost rates or run the risk of losing credibility with the markets. Greenspan, recognizing that as-yet-unmeasured productivity growth would mute price hikes, held rates down, a move which helped fuel the New Economy boom.
In general, it may become harder for the Fed to make moves that appear to contradict its inflation targets. "If we have something like September 11 again, the main thing you're trying to do is to restore public confidence," says a Fed policymaker who is against inflation targeting. "I sure wouldn't want to be caught having to think about a price stability target."
In some ways it's a little bit surprising that the urge to rein in the Fed's discretion should arise now. After all, Greenspan has been widely applauded as the best central banker ever. During his 18 years as Fed chairman, investors from Sydney to São Paulo hung on his every word, looking for hints of changes in interest rates and reassurance on the health of the U.S. and world economies. And as the economic answer to the Oracle of Delphi, Greenspan was avidly sought for his views on topics well outside the Fed's purview, from Social Security reform to the price of natural gas.
But despite Greenspan's success and prominence, many economists and Wall Streeters felt a vague discomfort with the way he handled monetary policy. "He has become increasingly seat-of-the-pants, which carries a lot of problems," says Jim O'Neill, head of global economic research at Goldman Sachs in London.
That's why economists as diverse as liberal Alan S. Blinder and conservative Friedman support Bernanke in moving to inflation targeting. Under this scheme, when forecasts predict that the rate of inflation is going to stray outside the Fed's target band, the central bank would defend its goal with hikes or cuts in short-term interest rates. Bernanke has described his inflation comfort zone as a 1% to 2% annual increase in prices, excluding food and energy costs.
Equally important to Bernanke's vision is clear communication of the Fed's goals and strategies to the markets. This is meant to increase the predictability of the economy and markets for investors and companies, making decision-making easier. "Bernanke appears to lean toward trying to take some of the shooting from the hip out of Fed policymaking," says David A. Lereah, chief economist of the National Association of Realtors.
Supporters of this strategy argue that a diminished Fed would still be able to get the job done. Indeed, in a crisis it would respond by flooding the markets with enough cash to prevent a financial system meltdown. Likewise, advocates of a restrained Fed say it wouldn't hesitate to cut interest rates and spur economic growth if deflation loomed. As evidence, they point to the leading role that Bernanke played in the Fed's decision in mid-2003 to push rates down to the rock-bottom level of 1%, and keep them there for a year, to guard against a deflationary downturn.
However, if the economy is faced with ordinary muddles, rather than sharply defined crises, Bernanke's Fed is more likely to err on the side of restraining inflation. "If you have a publicly announced inflation target, you're going to be a little bit embarrassed if you miss it," says Johns Hopkins University professor Laurence Ball, who has written extensively on inflation. "That's at some level going to put pressure on policymakers to put a little too much emphasis on reducing inflation."
The Bernanke Fed also could be slower to react when the housing boom ends. If the housing market does start to fall sharply, the Fed must decide whether to slash rates to cushion the economy. Under Greenspan, that move would come as second nature. An inflation-targeting Fed, however, would be constrained from acting until it was convinced that the housing bust would drive inflation below its target range. Only then could Bernanke and Fed policymakers decide to cut rates and by how much.
Bernanke insists he will guard the flame of Greenspan-style policymaking. Flanked by Greenspan and Bush at the Oct. 24 White House news conference announcing his nomination, he pledged to "maintain continuity with the policies and policy strategies established during the Greenspan years." Nevertheless, the Bernanke Fed is one that, for better or worse, is likely to be different and less grand than the Greenspan Fed.
By Rich Miller, with Paul Magnusson in Washington, Peter Coy in New York, William C. Symonds in Boston, Laura Cohn in London, and bureau reports