By MARY DEIBEL
Scripps Howard News Service
October 31, 2005
Bernanke's interest in "inflation targeting" would end much of the Fed's mystery by setting explicit goals for inflation control.
At the same time, the globalization and deregulation of financial markets will make it tougher for Fed actions to have the same force at home and abroad and for future Fed chiefs to reach Greenspan's mythical status.
The idea of Fed chief as economic wizard is a recent phenomenon for an institution whose obscure ways date back to the early 1900s when emerging American industrial might could ill afford the periodic bank panics that plagued the 1800s.
The Federal Reserve Act of 1913 created a system of regional Federal Reserve Banks governed by a central board to supervise the solvency of American banks and to clear checks and bank drafts back when money transfers moved by rail, horse or wire.
Eventually the Fed evolved into an economic policy locus, charged with controlling the supply and cost of money and credit to stabilize prices and encourage growth. Today, says University of Pennsylvania political scientist Donald Kettl, author of "Leadership at the Fed," "The Fed has become the economic policy-maker by default."
To Allan Meltzer, the Carnegie-Mellon economist who authored an exhaustive history of the Fed, the central bank has made some monumental mistakes:
- It worked hard under a string of chairmen in the Roaring '20s to re-establish the gold standard to which the U.S. money supply was pegged before World War I.
- It got so worried about inflation in 1937 that the Fed's policy-setting Open Market Committee under Chairman Marriner Eccles, a Utah banker, started raising interest rates just as President Franklin Roosevelt's plan to pay premium prices for gold to devalue the dollar had generated an economic turnaround.
Eccles does get credit for restructuring the Fed and America's banking system under the Banking Act of 1935, a law that undergirds the. financial system today, Kettl said. He also credits Eccles with working closely with FDR on New Deal programs so that the Fed coordinated with the White House without being controlled by it to put Americans back to work and pull the nation out of Depression.
Once the Depression gave way to World War II, the Fed backed "pegged," or fixed interest rates, to finance wartime expenses instead of letting interest rates fluctuate to control the money supply and growth.
Fed chairman William McChesney Martin negotiated an accord in 1951 in which the Fed could adjust interest rates and the money supply with an eye toward stabilizing prices as well as the economy. That ushered in the era of the modern Fed as an independent center of economic power.
But by the 1960s, in the face of the full-bore guns-and-butter policies of the Kennedy and Johnson years, the conservative Martin faced a dilemma: either the Truman appointee and Eisenhower holdover could stand his ground against inflation, or give in to White House pressure to expand the money supply to finance the Great Society and Vietnam war.
Martin told the Fed's Open Market Committee in 1963: "For the first time in a long while, the committee might find itself faced with serious problems with prices and with an incipient expansion at an unsustainable rate." It was an understatement: Martin biographer Robert Bremner notes that, by the late '60s, "inflation had become a whirlwind with Martin unabashedly playing the reaper."
Martin retired in 1970 after 19 years and appointments by every president from Truman to Nixon, the longest tenure of any Fed chairman.
Nixon replaced him with top Nixon economic adviser Arthur Burns, who was nothing like consensus-builder Martin: Burns led the charge and tolerated no dissent at the Fed. "What is the chairman supposed to be, a purely passive regulator, a policeman who keeps order or a leader?" he demanded.
Although ostensibly a free marketer who opposed government meddling, Burns pursued an expanded money supply as Nixon headed into the 1972 presidential race. But after Nixon handily won re-election, the president imposed wage-and-price controls to cope with inflation that tripled the rate of rising prices during the 1950s and '60s.
Once Watergate forced Nixon's resignation, the unelected President Ford campaigned against runaway inflation, urging Americans to wear "WIN" buttons for "Whip Inflation Now."
Burns biographer Wyatt Wells writes that Burns came to believe "the logic of events" dictated loose monetary policy on his watch: By Burns' retirement in 1978, two decades of post-World War II prosperity had given way to the collapse of fixed exchange rates, an Arab oil embargo that was the beginning of the end of cheap energy, a steep recession and runaway inflation.
It took President Carter's choice of Paul Volcker as Fed chairman in 1979 to finally break inflation's back
Volcker arrived with market-calming credentials. As president of the New York Federal Reserve Bank, he was second to the Fed chairman in power: The New York Fed chief carries out Fed open market operations, buying and selling government securities to affect the cost of money and availability of credit to steer the economy's course.
Volcker's tough policies as Fed chairman sent interest rates soaring to 20 percent and more. That stopped runaway inflation and got it to reverse course so that consumer prices stopped leaping at a 13.3 percent annual clip, rising a more modest 4.4 percent.
Still, Volcker's tight-money stance had its price: It provoked the worst recession since the Depression and cost millions their jobs, including Jimmy Carter.
Weeks after succeeding Volcker in 1987, Greenspan, intent on showing he could fight inflation, too, got the Fed to hike interest rates 0.5 percent only face a 508-point plunge in the Dow Jones average.
It was the first of many crises to come that included the rescue of the Mexican peso, containment of Asia's currency contagion and the Fed's rapid response to 9/11.
All burnished Greenspan's reputation and helped make the Fed chief into "the most important economic-policy job in America - indeed in the whole world," as the Economist magazine sees it.
Greenspan calls his style "risk management."
Bernanke will have to manage some risk starting with record budget and trade deficits that Washington gridlock has sown, helping send America's national debt above $8 trillion last week for the first time in history, with much of the money borrowed from China and Japan.
So the new Fed chief will need to convince investors here and abroad of the value of holding America's IOUs in the face of ongoing fiscal stalemate. With financial flows freed to go global in the click of a computer mouse, Kettl said, the Fed chief's new task won't lend itself easily to Wizard of Oz pulls on the old Fed policy levers.
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