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Tough Job
As the news "Fed Raises Interest Rates" rumbles through waves of air and newsprint, it would be nice to get the story straight. Nice, indeed, because the Fed will be on stage for one or more encores in the months ahead.
The story is nearly always gotten wrong, except in the fine print of technical media. It's too bad, as the Fed's operations are relatively easy to understand, and have such a huge impact on every day family finance: mortgages, retirement plans, mutual fund mania, and jobs.
Most of the confusion about the Fed has to do with its place in the political system, and exactly what it does when it tightens or eases.
For all practical purposes, the Federal Reserve System in nine men and women (or woman, as the case has been lately) who periodically vote to change their collective mind. Though the chairman gets all the ink, and is somewhat more equal than the others, he has only one vote. The nine Fed Governors are appointed by the President, and confirmed by Congress, just like Justices of the Supreme Court.
The Fed has almost as much power as the Court. The Fed Governors cannot be told what to do by the President, or by any other government official. Conspiracy theories to the contrary are mistaken. The Fed does consult with other parts of government, and from time to time will bow to the wishes of the White House, but it cannot be ordered to action.
As the Fed exists at the sufferance of Congress (the Fed is not mentioned in the Constitution), Congress does have some indirect control. If Congress thinks the Fed is unreasonably stingy, Congress can threaten to reduce the powers of the Fed. In a financial kabuki dance, the Fed then conceded, and opens the national wallet.
Congress never thinks that the Fed is too easy with money.
When the Fed tightens monetary policy, the typical news story says the Fed has raised "rates." The Fed does no such thing. The Fed raises (or lowers) rate. Singular, as in one rate.
That rate is known as the "Fed Funds" rate. Fed funds are money traded overnight between banks: just overnight, the shortest of all maturates. The Fed has absolute control over that rate, and no direct control over any other rate (except some historical relics like the "discount" rate).
Short term rates like "prime" tend to move quickly in response to a change in the fed funds rate. Most of the money in the world is short term. When most of the money in the world gets more expensive, the economy tends to slow down. When the economy slows down, so does inflation.
In this episode of tightening, most news stories have got it right that the Fed is trying to tighten early, and pre-empt future inflation before it gets going. Problem: there is no good leading indicator for future inflation. There are only indications of error.
Fed error consists of being either too late (inflation), or too early (an unnecessarily flattened economy). The error warning light is long term rates.
Long term rates, including mortgage rates, move in response to anticipated inflation. If the Fed is too late, long rates rise while the Fed is busily tightening. If the Fed is on time, or early, long rates will be steady, or fall, anticipating a weakening economy and lower inflation.
How do the Fed Governors know when, and how much to act?
For a while in the 80's, the Fed relied on the various measures of the money supply. Many conservatives want the Fed to follow an ironclad formula to control inflation: maintain a steady gold price, or hold a level price for a "market basket" of commodities, Certain liberal want the Fed to worry about jobs and economic growth more than inflation.
No matter what the political camp, most observers are nervous that nine human beings, subject to mistakes, bad days, bad data, and bad assumptions are guessing what to do.
But that's what they do. They collect all the information they can, cross their fingers and guess. No formula, no matter how big the computer, has been able to replace the Fed's star chamber, arbitrary, pin-striped, and anti-democratic proceedings.
At the moment, there are seven damp fingers stuck into an uncertain economic breeze, testing the velocity. It's only seven because two Fed Governors have moved on to greener pastures (and I do mean green), and have yet to be replaced. In another year, Mr. Clinton will have to decide whether to re-appoint Mr. Greenspan, or choose his own chairperson.
Another comparison of the Fed to the Supreme Court is useful. The Court applies and interprets written law, and is guided and limited by a huge body of decided cases. The Fed, on the other hand, has no steady guide. And, the pace of change in the financial world demands quick reaction and innovation unlike anything in the law.
The "laws of economics" are repealed, modified, found invalid, inapplicable, or absurd every day of the Fed's working life.
Mr. Clinton will nominate three governors and one chairman in the next eighteen months. A Governor's term is fourteen years; not for life, like a Supreme Court Justice, but a long time to suffer with a mistake.
Americans should pay every bit as much attention to the character, judgment, experience and opinions of new Fed nominees as they do to nominees to the Supreme Court.
After all, the Fed has a tougher job, and your job is riding on how well the Fed does.
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