By Steven Pearlstein
Wednesday, October 26, 2005
In all the hubbub over the appointment of Ben Bernanke to replace the irreplaceable Alan Greenspan, one inconvenient development has been ignored:
Thanks to the growing power of global financial markets, the job of Fed chairman ain't what it used to be.
For years, perhaps out of a primal need to believe that some wizard oversees the economic machine, everyone from Wall Street traders to Washington politicians to business editors has ignored that new reality.
Instead, they cling to the notion that the Federal Reserve chairman has a dial in his office that can control economic activity and inflation in the United States. When dialed up, the Fed's boiler room "pumps" money into the economy by printing extra dollars and using them to buy short-term government IOUs from big banks. Or, when the Fed raises interest rates, it sells its stock of IOUs, sucking dollars out of circulation. So great is this power that all the Fed must do is announce a change in the federal funds rate and banks reflexively raise or lower their prime lending rates.
In this outdated model, the all-powerful Fed chairman must figure out when, and how much, to tweak the interest-rate dial. In making those judgments, he has relied on elaborate models constructed by the Fed's research staff that forecasts the future of the economy based on how it has performed before. This fine-tuning assumes an unavoidable trade-off between inflation and unemployment: Reducing one means accepting more of the other.
The past 30 years, however, have not been kind to this Newtonian view of how the economy works. Periods of simultaneous high inflation and high unemployment (late '70s) or low inflation and low unemployment (late '90s) raised doubts about the trade-off of the Phillips curve. And the traditional link between money supply and the pace of economic growth began to break down. Structural economic changes -- globalization, deregulation, new technology and the shift from manufacturing to services -- have confounded the Fed's forecasts.
But perhaps the biggest change has been that big banks are no longer the main intermediary between savers and borrowers, pricing capital and channeling it to its highest and best use. Instead, complex new financial markets perform those functions more efficiently, using junk bonds and convertible debentures, collateralized debt obligations and other derivatives. A household is more likely to get a loan from a mortgage broker than from a savings bank. A growing company is as likely to get its capital from a private equity fund, mezzanine lender, venture capitalist or hedge fund as from a commercial bank. And the source of all this capital is as likely to be the central bank of China as a rich retiree in Palm Beach.
As a result of those changes, the Fed increasingly finds itself not leading markets but rushing to catch up with them. And it explains the "conundrum" of the Fed moving short rates one way while long rates move in the opposite direction. In terms of the federal funds rate, it now takes bigger changes over longer periods to have the desired effect on the economy. It also means that the Fed's main impact on the economy is not direct, through the "pumping" process, but indirect, through its powers of persuasion and regulation.
What does all this mean for Bernanke?
For starters, this is hardly the time to dabble with inflation targeting, which the chairman-to-be has long advocated. There is no harm in the Fed stating a goal of keeping inflation between 1 and 2 percent. But at a time when old regularities no longer hold, pragmatism and experimentation are needed, not a monetary policy on automatic pilot.
The new realities also put a premium on understanding financial markets and an ability to manage their inevitable crises. Bernanke acknowledged that during his brief tenure at the Fed, when he pushed the institution to signal its long-term strategy and explain its actions more clearly.
At the same time, the downside of Bernanke's distinguished academic career is that he brings little experience with modern financial markets or how they interact with the "real" economy.
Bernanke is smart and will figure out the markets before long. In the meantime, he ought to ask the president to fill two openings on the Fed board with governors who have market savvy and business experience.