The Federal Reserve is easily one of the most powerful—and misunderstood—of all American institutions. The Federal Reserve’s steady hand as America’s “central banker” has been especially critical to U.S. economic performance during the past 25 years. Why?

The management of fiscal policy (taxation and spending) was less than admirable during the majority of those years by various presidential administrations and congresses. As a result, the enormous and irresponsible buildup of federal debt remains, for now, our collective lasting legacy.

Today’s Federal Reserve, under the control of Chair Ben Bernanke, enjoys a very high level of credibility as an inflation fighter. In the world of central banks, there is no loftier objective—nor any greater success.

Inflation Control

The Federal Reserve’s number one responsibility is to maintain American price stability. It has been largely successful over the past 15 years in doing so, with consumer prices rising at an average annual rate of 2.6 percent since 1991. More comprehensive measures of inflation have risen at even lesser rates. In contrast, U.S. consumer prices rose an average of 6.2 percent annually during the 1970s and 1980s, with a painful bout of double-digit inflation in 1979 and 1980.

Today’s Fed is very concerned that higher energy prices impacting the economy will contribute to a broad series of price increases for thousands of products and services across the economy. Such a pass-through of energy costs keeps Fed officials awake at night.

Add in volatile commodity and gold prices, potential Avian flu, the fear of further terrorism in the United States and abroad, enormous purchases of U.S. Treasury securities by foreign investors, and a handful of other topics and one gets a feel for the life of a Fed official. It is not for the faint hearted.

In its efforts to maintain price stability, the Fed many times is called upon to:

1. “Take the punch bowl away from the party” (to slow the economy) when it gets a bit too rowdy.
2. Administer preventive “medicine” to its patient (the U.S. economy) when necessary in order to minimize the chance of a more serious “inflation disease” later, which would require even more drastic action (more painful medicine).

Note that most changes to monetary policy are enacted by the Fed adding reserves to or withdrawing reserves from the banking system through a process called open market operations. The result of such moves is to increase or decrease the Fed’s most critical interest rate, the federal funds rate. The federal funds rate is the rate at which commercial banks and certain other financial institutions invest excess funds with other commercial banks on an overnight unsecured basis.

The federal funds rate is easily the most important of all short-term interest rates. Changes in the federal funds rate immediately impact the level of all other short-term interest rates, including the prime lending rate and various short-term investment rates. The discount rate, the other rate controlled by the Fed, is now almost irrelevant to the conduct of contemporary monetary policy.

The Dog and the Tail

While many of the Federal Reserve’s official responsibilities remain unchanged from earlier years, the nature of the Federal Reserve’s monetary policy flexibility has changed markedly during the past 30 years. In my opinion, the Federal Reserve is no longer the primary determinant of when monetary policy changes are necessary—the U.S. bond market is.

Since the Federal Reserve’s creation in 1913 until the late 1970s, the Federal Reserve solely determined monetary policy. The nation’s bond market—much smaller during those times—quietly fell in line. During that era, the Federal Reserve was the “dog” while the bond market was the “tail.” This relationship is now reversed.

Today’s reality is that the Federal Reserve, to a large extent, provides the monetary policy mix that is demanded by a powerful and very inflation-sensitive bond market. The market is now the “dog,” while the Federal Reserve is the “tail.”

Today’s inflation-wary bond market provides the Federal Reserve with less monetary policy flexibility than at any time in its history. Any future Federal Reserve attempt to overstimulate U.S. economic growth with “easy money” would be met with rising long-term interest rates (in order to protect lenders and investors from impending higher inflation) and cries of Federal Reserve irresponsibility. See Silver Bullet #3 later in this chapter.

Conducting Monetary Policy

How does the Federal Reserve determine proper monetary policy? The Fed is clearly concerned about the inflation implications of today’s historically tight labor markets and the wage pressures that could result.

Figuratively speaking, today’s Federal Reserve conducts monetary policy using an old-style balancing scale with four trays in which the Fed balances:

1. Criticism from the “hawks” who see inflation under every rock. The hawks are typically critical of the Fed, noting that the institution is not aggressive enough in diffusing inflationary expectations.
2. Criticism from the “doves” who constantly argue that monetary policy is too restrictive. The doves argue that the Fed has usually gone too far in monetary tightening or has not eased policy enough, and that the Fed frequently threatens the economy with the “r” word—recession.
3. Recent price performance of gold and various other commodities. Price movements in these commodities can serve as inflation red flags, as well as signs of monetary policy that is too restrictive.
4. The current shape and slope of the U.S. Treasury yield curve, including the most recent direction of 10-year U.S. Treasury Note and 30-year U.S. Treasury Bond yields. Such information provides a clue as to the bond market’s collective view of inflation expectations.

Only when all trays are in “relative balance” does the Fed consider monetary policy to be appropriate.

The Fed must also consider the inflation implications of U.S. dollar strength or weakness relative to other global currencies. The Fed must also consider the conduct of monetary policy by other major central banks including the European Central Bank, the Bank of England, and the Bank of Japan.

Monetizing the Debt

A question I am frequently asked is, “Won’t the Federal Reserve at some point be forced to ‘monetize the debt’—that is, to buy huge additional amounts of U.S. Treasury securities with newly created money—and finally deal with the $9.0 trillion gross national debt?” My answer is always no.

Of all the things one can worry about in the “dismal science” of economics, that question is one over which I never lose any sleep. History, especially in certain Latin American and European countries, provides vivid illustrations of how central bank abuses of monetary policy have led to short or extended periods of hyperinflation.

Today, however, the powerful U.S. bond market—now the Federal Reserve’s overseer—simply will not allow that “easy solution” to the deficit problem. The new “dog”—the bond market—is now firmly in control.

The Maestro

Alan Greenspan will enter the financial history books as one of the most highly regarded Chairs of the Federal Reserve. His reign of just under 19 years was the second longest ever, from 1987 to early 2006, during which he served under four U.S. presidents.

Mr. Greenspan was at the monetary controls during the stock market crash of 1987, the 1990–1991 recession, the Asian financial crisis of 1998, the Long-Term Capital Management meltdown soon after, the recession of 2000-2001, the horrific events of September 11, 2001, and on board during most of the longest bull market in stocks in history. He also minded the store during one of history’s most painful stock market corrections.

Mr. Greenspan did an outstanding job during his reign at the Federal Reserve. His stature and respect in the nation’s capital was second to none. Greenspan took bold steps during his tenure to remove much of the Fed’s operating mystique. His push toward greater openness and “transparency” was very favorable.

The New Kid

Prior to 2001, current Federal Reserve Chair Ben Bernanke was largely unknown in global financial circles and served as head of the economics department at Princeton University. He ultimately served as a member of the Federal Reserve Board from August 2002 to June 2005.

Bernanke rapidly became the second most influential person on that seven-member board. In June 2005, he was selected by President George W. Bush to serve as the Chair of the President’s Council of Economic Advisors, presumably in an effort to broaden his government experience. His nomination to lead the Federal Reserve followed in late 2005.

The learning curve of the Fed Chair is a very difficult one and not for the faint of heart. Bernanke had the big shoes of Alan Greenspan to fill, just like Greenspan had a learning curve to fill the big shoes of Paul Volcker in the mid-1980s.

Many people initially questioned Bernanke’s inflation-fighting resolve, a perception that needed to be reversed quickly. Fed Chair Ben Bernanke stumbled a few times in trying to get comfortable in what is arguably the second most important job on the planet. His every word drew intense scrutiny and analysis. Many of us in the “crystal ball gazing” community would argue that no other person in the American economy, including the president, has more day-to-day impact on our lives in the form of influencing inflation and interest rates.

The Speech

Every Fed Chair is forced early in their reign to give what I call “the Speech.” It is a no-holds-barred personal testament that the Fed under their leadership will keep inflation at low levels, even when such policy can upset politicians, consumers, and financial market players in the United States and around the world. While such resolve can clearly disappoint financial markets in the short-run, such policy is the essential groundwork for sustained, noninflationary growth and higher stock and bond prices in coming years.

Bernanke has continued his predecessor’s moves towards transparency. Earlier in his professional career he expressed support of “inflation targeting.” This entails announcing a targeted annual range for inflation pressures (say 1 percent to 2 percent) and then modifying monetary policy as needed to stay within the range. This practice is closely followed by the European Central Bank.

Greenspan opposed inflation targeting, preferring the flexibility to modify monetary policy to meet his whims and those of the financial community. One policy is not necessarily better than the other.

Fed Chair Greenspan had a unique ability to talk a great deal and say very little. Greenspan’s ability to construct lengthy sentences—packed with verbiage foreign to many—was legendary, leaving many listeners scratching their heads. In contrast, Bernanke’s style is much more direct, with short responses to questions, using words and phrases with which we are more familiar.

The Next Chair

It was very clear to financial market players in 2005 that President Bush would nominate a new Federal Reserve Chair from a select list of highly qualified people. Why? This country learned a painful lesson when Jimmy Carter was president in the late 1970s.

At that time, Carter decided not to reappoint powerful Arthur Burns as Chair of the Federal Reserve. He opted instead to replace him with a monetary unknown named G. William Miller, then serving as Chair of Textron Corporation.

The reaction on Wall Street and of the global financial community was one of utter disbelief. Miller knew little of monetary policy, was merely viewed as a Carter puppet, and suffered an enormous lack of credibility, particularly with bond and foreign exchange markets around the globe.

Timing is everything. Monetary policy credibility was a major necessity in the late 1970s as inflation and interest rates kept moving higher and higher, while the U.S. dollar was falling lower and lower. In essence, the emperor had no clothes.

President Carter was ultimately “forced” by financial markets to replace ineffective Fed Chair Miller with a highly regarded monetary expert, Paul Volcker, in order to right a ship listing badly. Such monetary history clearly suggests that when Bernanke ultimately steps down, he will be replaced by someone from a short list of men and women with whom financial markets would be entirely comfortable.

Credibility

The Federal Reserve is a most unique institution. It has the ability to create and destroy “money” at will. (This process has nothing to do with a printing press and a great deal to do with open market operations. See again the prior discussion in this chapter.) Such power is an awesome responsibility.

The Fed must have unquestioned credibility as an inflation fighter. The Fed under Chairs Burns and Miller (1970s) lost it…the Fed under Volcker gained it back…the Fed under Greenspan strengthened it…

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