New York – The mighty Federal Reserve. It’s more powerful than a ballooning housing market, able to stop inflation in a single bound. And, if it slips, if it uses its superpowers unwisely, if it goes too far, it could push the economy into recession with a nudge of its pinkie.
That’s one way of looking at the nation’s central bank. Under outgoing Federal Reserve chairman Alan Greenspan, it has become the main way. The Fed is seen as the arbiter of all things economic, with Greenspan as its ruler and resident hard-to-understand genius.
With his seat at the central bank expected to be turned over to Ben Bernanke in January, it’s time for a reality check.
Just how powerful is the Fed? The Fed has two missions, said Quincy Krosby, chief investment strategist at The Hartford, the Connecticut-based insurance company. Its primary mandate is price stability, keeping inflation at bay. Its secondary charge is maintaining an environment of sustainable economic growth, which is interpreted to mean sustaining jobs.
To achieve its missions, the Fed has two main tools: It regulates the money supply and increases or decreases short-term interest rates. More money plus lower interest rates are the tools of an “accommodative” Fed, a Fed trying to spark economic growth.
If the Fed decreases the nation’s money supply and raises interest rates, it is tightening, trying to slow the economy and stave off inflation.
After 12 rate hikes in a row, the short-term federal funds rate is at 4 percent, a four-year high, and Wall Street watches the Fed with rapt attention.
When the Fed released notes from its most recent policy meeting, traders bid stocks higher after sensing a glimmer of hope that an end to the Fed’s rate hikes was in sight. News that the Fed might stop giving strong hints about where rates are heading was the top story recently in The Wall Street Journal.
Wrote Stephen Wood of Russell Investment Group: “It is Fed interest rate policy that drives economic cycles. In the context of today’s financial news flow, investors would do well to remember that oil, terrorism, natural disasters, etc. gain significance relative to current Fed policy.”
Citigroup strategist Ajay Singh Kapur quotes an old market adage: “Economies don’t die of old age; they are always murdered by the central bank.”
Eight of the past 12 recessions were preceded by Fed rate hikes, he said, a figure that is mentioned and repeated often by the “all- powerful Fed” school of Wall Street strategists these days.
That is nonsense, said Sandy Lincoln, chief market strategist at Wayne Hummer Asset Management in Chicago.
There are factors that are beyond the Fed’s control, Lincoln said, such as the introduction of the euro, the globalization of the economy and the current increases in commodities prices.
“The Fed doesn’t murder economies,” he said. “The Fed doesn’t create these cycles. … They can get it wrong, but over the last 30 years, they’ve gotten it right more often than they’ve gotten it wrong. At the critical time, they really got it right.”
While investors are growing impatient with the Fed’s rate hikes, it’s important to remember that at the start of this tightening program, rates were at a 45-year low.
What the Fed is trying to do is take the air out of the housing bubble, slow the larger economy and see employment edge slightly lower.
“The key is a slowdown, not a crash,” Krosby said. Still, when the Fed has finished, people will get hurt, she said.
Speculators could be in particular trouble. “The more leveraged you are, the more vulnerable you are to losing,” she said. “Instead of flipping condos, you could be flipping burgers – and I don’t think the Fed cares. What the Fed cares about is the average American.”
Even those who believe in the Fed’s powers don’t necessarily think it’s an institution to fear.
“Think of this Fed-induced slowdown like hitting the ‘Reset’ button on the economy,” Wood wrote. “Short term it can be grueling, but longer term (it is) good for stocks: It lowers interest rates, lowers inflation, works off excesses and creates the expectation for increased corporate profits. Mostly, it will get the Fed off our back.”
What he’s saying is that only the Fed can call off the Fed.
Now, that’s power.
