Many news reports on the Federal Reserve’s response to ongoing problems in financial markets misinterpret what it is doing. This is not unusual. The Fed is a complex organization that many professional economists don’t fully understand, let alone reporters.
But while faulty reporting on the Fed is common, the stakes are higher right now. Public misunderstandings about how the Fed operates and just what it can and cannot do create unrealistic expectations in financial markets and the general public. Such expectations foster bad business decisions and counterproductive public policies.
The most common error in reporting on the Fed is to overestimate the power of the chairman of the Board of Governors. Whether it’s held by Ben Bernanke or Alan Greenspan, the role has much less power than people believe. The Fed is not a dictatorship. Power over key decisions is diffuse and not readily apparent. General business reporters can be excused for missing details. Wall Street gurus claiming to be Fed experts have less excuse.
(By way of disclosure, I was a low-level economist at the Federal Reserve Bank of Minneapolis from 1992 to1997. I did not participate in any high-level policy meetings, but I did sit in on the bank’s monthly board of directors’ meetings and drafted the Ninth District’s section of the Beige Book report on economic conditions that comes out eight times a year.)
As insecurity has grown in financial markets over the past two weeks, two variations of the same question keep resurfacing: “Why doesn’t the Fed lower its target for the Fed funds rate?” and “Why doesn’t Bernanke do something?”
There are simple answers to these questions:
- If the Fed does not lower interest rates, that is because there is not a strong majority of members of the Federal Open Market Committee in favor of doing so.
- Bernanke does not have the legal authority to change any monetary policy by himself. Depending on the measure, he must secure a majority vote in either the 12-member FOMC or seven-member Board of Governors. Often this is not easy.
The FOMC is by far the more-important body. It sets the Fed funds target, currently 5.25 percent, that governs just how the money supply is increased or decreased. The voting members of the committee consist of the seven members of the Board of Governors and five of the 12 Federal Reserve district presidents. But the seven non-voting district presidents also participate in most committee deliberations.
The seven governors control only one monetary instrument by themselves. They can vary the discount rate charged on the Fed’s direct loans to private commercial banks. But they can do so only if at least one of the 12 district banks requests a change. They cannot initiate changes themselves.
After much public clamor, the FOMC held a conference call meeting Aug. 16. The next morning, the Board issued two press releases.
One was a classic FOMC statement, noting that “tighter credit conditions and increased uncertainty have the potential to restrain economic growth” and saying it would “act as needed to mitigate the adverse effects on the economy.” But it announced no concrete action.
The Board of Governors issued a separate press release lowering the discount rate to 5.75 percent and issuing an unusual “altar call” invitation for banks to come and borrow.
News stories folded the two releases together, but they missed what was between the lines.
Two press releases by two different bodies suggest a split among Fed leaders. A majority of the FOMC did not want to act. A majority of governors did. Therefore, at least some of the voting district presidents are opposed to acting.
Two details are important. The statutory FOMC structure is seven governors and five voting presidents. But two board seats are vacant right now, so it is a five/five split. Any dissents count more in a 10-member committee than in one with 12.
Second, the cut in the discount rate came after a request by only two district banks – New York and San Francisco. That means 10 other districts did not push for a change. Acting on such a small number of requests is unusual for the Board of Governors. For the previous change, on June 29, 2006, 10 of the 12 districts had requested an increase.
The fact that only two of 12 districts requested a cut is not casual happenstance. The Federal Reserve Act requires each district’s nine-member board of directors to confirm their bank’s discount-rate position twice a month. So as of Aug. 16, 10 district presidents had not yet pressed their respective boards for a cut.
The Fed may well lower its Fed funds target and increase the money supply more rapidly. That may be sound policy. But it is not, and should not, be the slam-dunk measure that Wall Street insiders want the public to believe.
© 2007 Edward Lotterman
Chanarambie Consulting, Inc.