Online NewsHour: The Federal Reserve Board

THE FED

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August 20, 1996: Paul Solman reports on the Fed's decision to leave interest rates unchanged.
July 16, 1996: Elizabeth Farnsworth reports on a tumultuous few days in the markets.
Sept. 6, 1996: A report on the latest--and lowest--unemployment numbers.
March 11, 1995: A report on the mini-crash of March 1996.
The NewsHour Economy Page.

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The Federal Reserve Board.

It is a familiar cliche that the chairman of the Federal Reserve Board and its 12 regional banks is the second most powerful man in the U.S. because of his close grip on the direction of the nation's economy. Even in an election season, when so many threats and promises hinge on not only the state of the economy but on the voter's perception of it, it is crucial to understand the role of the Fed and its chairman for the next four years, Alan Greenspan.
If there is one overarching characteristic to Greenspan's stewardship of the Fed, it is his vigilance against the economy's premier bogeyman: inflation. Inflation occurs when the economy grows faster than what its resoures can handle. Real, safe growth of the GDP is a function of how much labor and capital are available and how productive these "inputs" are. If the economy consistently grows faster than its potential, industries and regions will run out of either workers or materials, or both--resulting in rising wage demands and rising manufacturing costs. Both these lead directly to rising prices--inflation.
Inflation is the beast that Greenspan most wants to control; he does this through manipulation of short-term interst rates. Every quarter, the Fed makes its decision: raise rates, lower them, or leave them alone. On August 20, it decided to leave rates unchanged, a sign that it is satisfied with the "steadiness" of the economy.
The Fed's decisions on short-term rates are part of a long and sometimes counter-intuitive chain reaction that involves its own periodic decisions, the volatile financial markets, and Administration announcements on economic indicators such as unemployment. For example, if President Clinton announces a drop in unemployment, he gets political credit; more people are at work. But to the Fed, this is worrisome; too-low unemployment can put upward pressure on wages--through supply and demand--and cause inflation.
The bond and stock markets markets know this reasoning all too well. A hike in short-term interest rates is murder for the markets: less people borrow money at high rates, so there is less money circulating in the economy. This means less investing and less purchasing, and is known as a "tight" money policy. It is a weapon to keep inventories up, demand down, and so prevent inflation. Thus, good economic news from the government is bad news for the bond and stock markets, and bad news for short-term investors.
An election year invariably brings talk of tax cuts, of alleviating the burden on the American family. A large part of the Republican Revolution, and its Contract with America, was, and is, tax cuts. The centerpiece of Bob Dole's economic plan is a 15 percent across-the-board tax cut. And yet no matter who wins Congress, no matter who wins the Presidential election, Alan Greenspan, politically secure in the first year of a four-year appointed term, holds an informal but effective veto over any tax cut proposal that surfaces.
Supply-side economics, the idea that a tax cut will stimulate economic growth while swelling American incomes, and balance the budget with a smaller tax slice of a much larger GDP pie, has and perhaps will always have a visceral appeal to voters. It is optimistic, promising growth, jobs, and lower taxes all at the same time. And mathematically, it adds up, if the economy can sustain a significantly higher rate of growth.
But Greenspan the economist says that it cannot. The economy is now growing steadily at approximately 2.5 percent a year, exactly a rate which he is comfortable, and incidentally a target that most economists name as safe for non-inflationary growth. If tax cuts spur the economy to grow too fast, Greenspan will raise interst rates, riling the markets and putting the brakes on growth, all in order to prevent inflation. The mere threat of such a move was enough in 1992 for President Clinton to curtail a public investment plan he had and turn instead to cutting the deficit; it will be enough to derail any tax cut plan not paid for by equal cuts in government spending. In other words, a tax cut that will not increase the budget deficit by reducing government revenue.
The primary job of the Federal Reserve is to curtail inflation--and potentially inflationary practices. Under Alan Greenspan, inflation is down from a high of 6.25 percent in 1990 to 2.6 percent today. He is doing his job, he feels, and doing it well. His mission is to ensure that growth of the GDP remain at sustainable levels, and that inflation remain at tolerable ones. And short-term interest rates are his primary weapon.

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