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The Myth of the All-Powerful Fed

By Allan Sloan
Tuesday, November 1, 2005

We all like to believe that there's an all-knowing, all-powerful force looking after us. No, I'm not talking about organized religion and God. I'm talking about the widespread belief that an all-powerful Federal Reserve Board controls interest rates and inflation and is looking out for each and every one of us.

Since President Bush nominated Ben Bernanke to become the next Alan Greenspan, we've heard endlessly about the Fed's powers over the financial markets and the economy, and about how hard it will be for Cousin Ben to fill Uncle Alan's shoes. But despite the outsized attention that any utterance from the Fed chair typically gets, the economic world isn't controlled by one person, or even one institution.

Bernanke will be a powerful guy, of course, and well worth watching and listening to. But you've got to remember two things about the Fed.

First, it's not looking after your personal interests -- it's looking after the financial system, which isn't the same thing. For instance, in the early 1990s, when many major banks were effectively insolvent, the Fed bailed them out by lowering short-term rates, handing them huge profits at the expense of people who depended on CD income for food money.

Second, the Fed is far from all-powerful. In fact, it's considerably less powerful than it was when Greenspan took the helm in 1987. Since then, the United States has become dependent on the rest of the world -- especially the central banks of Japan and China and other Asian countries -- to finance our budget and trade deficits. If Asia grows less eager to hold dollars, U.S. interest rates will rise, regardless of the Fed's wishes.

On the domestic front, our largely deregulated financial system is far harder for the Fed to influence than the old regulated system was. When interest rates paid to depositors were regulated, the Fed could raise short-term rates, lure money out of banks into Treasury bills and slow down bank lending.

Now, with no interest-rate ceilings and non-bank lenders such as hedge funds abounding, the Fed's influence has waned.

The one important interest rate the Fed controls -- the federal funds rate -- drives short-term interest rates. Sure, that's important if you're in hock to a credit card company. But the fed funds rate doesn't drive long-term rates, which are set by financial markets and are far more important to businesses and home buyers.

In fact, during Bernanke's stint as a Fed governor, he tried to talk down long-term rates by threatening to have the Fed print money to buy up long-term bonds. Had that happened, the markets would have bested the Fed the way they bested the Bank of England in 1992 when it spent billions trying to defend the British pound. He raised a hue and cry about the prospect of deflation, but it never appeared.

The fact that Bernanke isn't perfect shouldn't be cause for alarm. Neither is Greenspan, as he'd be the first to admit if you bought him a couple of beers and promised him anonymity. He's been very good. But the stock bubble grew and burst on his watch, and we've now got a housing bubble that will inevitably burst. Last year, Greenspan talked about how foolish home buyers had been to get fixed-rate mortgages rather than variable-rate ones -- but given the sharp rise in short rates, anyone who switched to a floating-rate loan is wailing the blues today.

What I like best about Greenspan is that he plays things by ear and won't say what he's really up to. That magnifies the Fed's influence by keeping big market players off balance. The players care only about making money, but the financial system needs balance, which the Fed provides. With the Fed less powerful than it once was, guile is good.

We won't know how effective a Fed chairman Cousin Ben will be until after his first crisis. But one thing we know already: a divinity, he's not.

Sloan is Newsweek's Wall Street editor. His e-mail issloan@panix.com.

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