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 | THE POWER OF THE FEDERAL RESERVE December 20, 1996 |
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Questions asked in this forum:
Federal Reserve Governor Lyle Gramley answered your questions.
NewsHour Backgrounders
December 6, 1996: Seven simple words describing the stock market in a speech by the Chairman of the Federal Reserve, Alan Greenspan, sent markets around the world into a sharp downward spiral. .
July 3, 1996: Paul Solman looks at the role the Federal Reserve plays in the U.S. economy.
October 30, 1996: The debate over what constitutes a sustainable rate of financial growth.
August 20, 1996: Paul Solman reports on the Fed's decision to leave interest rates unchanged.
An Online NewsHour backgrounder on the U.S. economy.
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.
OUTSIDE LINKS
The Federal Reserve Board.
It is a familiar cliche that the chairman of the Federal Reserve Board is the second most powerful man in the U.S. because of his close grip on the direction of the nation's economy. Events at the beginning of December have borne that theory out.
On December 5th in
Washington, Federal Reserve Chairman Alan Greenspan gave a speech to a Washington research organization. In that speech he likened the current stock market to a "bubble" and asked, "How do we know when irrational exuberance has unduly escalated asset values?"
His speech sent the world's stock and bond markets into an overnight downward spiral. The next day, the Japanese stock market plunged 3.2 percent, its largest drop in a year, Hong Kong's market fell almost 3 percent, Germany's market fell 4 percent, English traders finished the day losing 2 percent of their market value, and the New York Stock Exchange plunged 145 points, or about 2 percent, within the first 30 minutes. By the end of the dramatic day, the Dow Industrial Average recovered substantially, regaining 2/3 of its lost value, but it still finished down 55 points.
The Federal Reserve System, the central bank of the United States, has not always wielded so much global power. It was founded by Congress in 1913 to provide the nation with a safer, more flexible, and more stable monetary and financial system; over the years, its role in banking and the economy has expanded.
The functions and goals of the Fed are well documented, but behind-the-scenes decision making is a closely kept secret. Every quarter, the seven Governors of the Federal Reserve Board meet to discuss the state of the economy. Every week the Fed considers requests from the 12 regional banks for changes in its discount rate, the interest the central bank charges to make loans to commercial banks. Those discussions take place in secret and the number of banks that are petitioning for interest rates to be changed has always been tightly held. That is why a September 1996 leak of information concerning how many banks wanted the rates changed sent a shock through the financial world. Officials at the Federal Reserve and private economists characterized the incident as an unprecedented leak of sensitive information regarding monetary policy.
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 resources 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. In August, and then again in November 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.
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 remains at sustainable levels, and that inflation remains at tolerable ones. And short-term interest rates are his primary weapon.
Our forum asks: What is the role of the Federal Reserve in today's economy and political culture? Do Americans realize the full power of the Federal Reserve, and if not, what do we need to know so that we can better understand the economic forces that effect our everyday financial decisions? Is the Federal Reserve System the best way to run an economy?
Our guest is former Federal Reserve Board Governor Lyle Gramley. Currently, Mr. Gramley is a Consulting Economist with the Mortgage Bankers Association of America (MBAA). He has also served on the President's Council of Economic Advisers.
Scroll down to read Lyle Gramley's answers to your questions.
- Was it wrong for Greenspan to make the statements he did?
- A teacher asks what can be done to improve the economic literacy of the public.
- Why was inflation so high in the late 1970s, and could the Fed have prevented it?
- What goes on behind the closed doors of Federal Reserve Board meetings?
- Why won't the Fed allow growth to pick up to reduce unemployment below 5.5% to test the "natural" rate hypothesis?
- More of your questions and comments.
A question from Nathan Bair of Edwardsburg, Michigan:
Should measures be taken to prevent Mr. Greenspan and future Federal Reserve Chairmen from making public comments outside a formal press conference?
Lyle Gramley responds:
Nothing would be gained by requiring a Federal Reserve Chairman (or other Federal Reserve officials) to confine their remarks to formal press conferences. Their public comments would still lead to market reactions no matter what format they took.
I think public officials have an obligation to make themselves available to the public by making speeches and other public appearances. Clearly, they need to choose their words carefully to avoid roiling markets, and under most circumstances, they do. But sometimes even very carefully chosen words can lead to pronounced market reactions, as evidenced by the world-wide stock market responses to Chairman Greenspan's remarks about "irrational exuberance." I think Greenspan's comments on that occasion were both timely and appropriate. In November, the Standard and Poor's 500 index rose at an annual rate of 77 percent. If stock prices continued to increase at such a rate, they would soon be out of touch with reality (if they are not already), and that would be a source of economic instability.
A question from Laura Wolff of St. Louis, Missouri:
I teach economic principles to several hundred university students a year and I'm amazed at how little knowledge they have prior to the course that the Fed exists much less has any role to play. What do you think can and should be done to improve the economic literacy of the public, specifically about the Fed, but also about other economic concepts that are important to their everyday decision making and knowledge base as citizens trying to understand and advocate for policy changes? What kind of changes should be made to current media coverage of economic events? Can more astute "public relations" and wider promotion of understanding economics by the public information arms of the Fed help? Should the Board of Governors have more responsibility in this area?
Lyle Gramley responds:
The state of public knowledge about the economy in general and the Federal Reserve in particular certainly isn't because of lack of available information. The issue is how to get people interested enough in the subject material to take the time to educate themselves.
The Federal Reserve has spent a lot of effort to improve public awareness if its purposes and functions. The public relations department of any Federal Reserve Bank would be more than happy to help out in any way they could.
If I were teaching economics to university students, one source that I would recommend to them is the Web pages of the Federal Reserve Board and the 12 Reserve Banks on the Internet. You can start at the Board's Web page and branch out to any of the 12 Reserve Banks from there. The Board's Web page is: www.bog.frb.fed.us
A question from Linda Fortinbras of Dallas TX:
Could you talk about the time period in 1979 when President Carter replaced Federal Board Chairman G. William Miller with Paul Volker? Wall Street and the Federal Reserve Board seemed to be at war then. Was the price of oil the reason for such high inflation, or was the Fed responsible in some way? Some of my colleagues argue that Miller was a political player, and very loyal to Carter- but was he really helping Carter by not raising interest rates fast enough to suppress inflation? Since Miller, the trend seems to be to appease Wall Street with banker-type Chairmen. Has Wall Street won?
Lyle Gramley responds:
Price and wage developments in the latter half of the 1970s were a culmination of an inflationary process that got underway a decade earlier and continued until the Federal Reserve took decisive action, beginning in late 1979, to bring inflation under control. Oil prices were only part of the problem; the larger issue was that public policies, both monetary and fiscal, gave insufficient attention to the damage being created by inflation.
I am sure that the Carter administration, if it could redo the policies it pursued from 1976 to 1980, would give a lot more attention to the problem of inflation. The problem wasn't just Bill Miller, but the course of monetary and fiscal policies over a period of 15 years.
To be sure, since Bill Miller the Federal Reserve has placed a much higher priority on price stability than at any time previously in the postwar period. Wall Street hasn't won; the nation has.
A question from Peter Kasper of Arlington, VA:
When the Fed Governors meet, what happens? Are there debates and then a vote? How much vigilance is given to keep the board diverse-And I don't just mean differing economic theories represented, I mean diverse backgrounds and interests. There is an argument to be made that the FED doesn't watch out for the public interest, but rather watches out for the 12 member banks-those interests cannot be the same!
Lyle Gramley responds:
Decision-making at the Federal Reserve Board is not a mysterious process. It is very well organized: a written agenda and accompanying materials are sent out ahead of time for review by the individual Governors; at the meeting, staff briefings are normally given on each of the agenda items; then, debate begins and finally a vote is taken. Some Board meetings are required by law to be open to the public. Interested persons can attend meetings and see for themselves how they are conducted.
Making sure the constituency of the Board is appropriate is the responsibility of the President and the Senate, which must confirm the President's nominees to the Board. The law requires that each of the Members of the Board come from different districts, but there are no other formal requirements for diversification. The public is sometimes unhappy with the Federal Reserve when interest rates have to be raised to control inflation, but it is simply a bad rap to say that the Fed is primarily interested in the welfare of the 12 Reserve Banks.
A question from Derek Sicklen of Sydney, Australia:
The Federal Reserve Board conducts monetary policy based on the notion that there is a "natural" rate of unemployment and that if the unemployment rate were to be allowed to fall below this "natural" rate then inflation would accelerate. But estimates of this "natural" rate have been consistently too high over recent years and inflation has not re-ignited when the actual unemployment rate has fallen below the best estimates of the "natural" rate. Currently the "natural" rate is estimated at 5.5% and this may be too high still. Why won't the Fed allow growth to pick up to reduce unemployment below 5.5% to test the "natural" rate hypothesis?
Lyle Gramley responds:
It is quite true that estimates of the "natural" rate of unemployment have come down in recent years. A few years ago, a common estimate was 6 to 6-1/2 percent; today, most estimates I have seen run in the 5-1/2 to 6 percent range.
Why doesn't the Fed let the economy grow fast enough to push the unemployment rate below 5-1/2 percent, to see if the natural rate might be below that? It already has! The unemployment rate has been consistently below 5-1/2 percent since May 1996. The Fed is, however, probing cautiously, and rightfully so. Although inflation has shown no sign as yet of increasing, wages and salaries have begun to inch up in an environment of widespread anecdotal evidence of labor shortages.
Additional Comments...Joyce Millard-Hoie of Virginia Beach, VA
Isn't the Fed just another player in the marketplace? There is such a complex interplay of forces involving market sensitivity, wage and employment issues, political considerations, etc. that I wonder whether the system is actually being managed at all. Decisions from the Fed are essentially reactive, and yet capable of exerting globally significant effects on the political, social, and economic environments.
Heinz W. Puppe of College Station, TX
The media needs to explain the role of the Federal Reserve (it supplies the "money" needed to run the economy) but also the function of the National Debt. The National "Debt" is not a debt in the common, personal sense, i.e., money owed to banks, mortgages, etc. Questions people fail to ask themselves: to whom do "we" the country, the "government" owe this money? Why do the "creditors" "lend" more and more money to this mysterious debtor (that's "us" when that debtor is supposedly bankcrupt, "owing" 11 trillion $$). To whom? We owe this to ourselves. Please, spread the word.
John T. Durkin of Canton, Ohio
Today, when asked, a great majority of the population of the United States could not tell you what the Federal Reserve is, or who Alan Greenspan is. They might tell you that the Federal Reserve is the bank that was robbed in the movie Diehard: With a Vengence. People really need to get hip on who and what the Fed really is and how it influences their lives every day.
Christopher Barrett of Merritt Island, Florida
I am amazed to read that there is an organization sanctioned by the U.S. Government that operates in secret for the purpose of controlling the economic health of U.S. citizens. Isn't this obvious deceit? This nation teaches its children that we are a free and open society. We are almost militant in our efforts to make other nations see the light. The U.S. government goes to great lengths to open international markets and claim that an open market economy is the road to the well-being of all people. The Federal Reserve apparently has been given the power to control a free economy in secret and also is in no way controlled by our representatives.
Wayne Boufford of Hyannis MA
I find it very difficult to understand how Mr. Greenspan and his group of cronies (I'm sorry....board of directors!), have the control that they posess....Who gave them this control and who oversees their decision making process as well as their personal motivational gains? The answer "Mr. Clinton" does not hold water. Are they really just playing God with the economy of this country and who are they really accountable to?
Linda A. Singer of Reston, Virginia
I shudder to think that one man, Alllen greenspan, can make a statement which affects millions of Americans whose pensions are based on the Stock Market. His statement cost my family a great deal of security in the way the market went down after his statement and continues to go down. No one should have such power. It is as if the Federal Reserve Board Chairman and not the President or Congress has control over our pocketbooks and our security. He is not elected but holds his job because if he is replaced there is fear that may in itself cause the markets to make major adjustments. The federal reserve Board should have a check on it as do the three branches of our government.
Hyman Blumenstock of Columbia, MD 21045
Baron M. A. Rothschild: "Give me control over a nation's currency and I care not who makes its laws."
Charles A. Lindbergh Sr. at the time of the passage of the Federal Reserve Act in 1913.
"This Act establishes the most gigantic trust on earth. When the President signs this Act the invisible government by the money power, proven to exist by the Money Trust Investigation, will be legalized. The new law will create inflation whenever the trusts want inflation. From now on depressions will be scientifically created."
Henry Ford, founder of the Ford Motor Company, commenting on the privately owned "Federal" Reserve scam:
"It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning."
Why are Americans forced to surrender their rights under the supreme law of the land, the U.S. Constitution by an agency that has no authority under the U.S. Constitution or by any powers granted by the U.S. Congress?
David Fredericks of Huntington Beach, CA
Is it not true that little people, who benefit the least from capital gains and corporate profits, are essentially the ones punished for the specula tive excesses of the rich? And, though one not ought expect fairness or justice in life, would it not be better for the economy and the psychological climate of money markets if there were more equity in the Fed's actions? It seems to me that the Fed could allay the Social Darwinism and dangerous con centration of wealth that makes our economy look, simultaneously, like a depression and "the sky is the limit" for profits without end.
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