From the January 2008 issue of Research Magazine • Subscribe!

First-Hand Look at the Fed

Since last September, Vincent Reinhart has been resident scholar at the American Enterprise Institute, a Washington think tank, where he has the freedom to conduct research and no set responsibility to produce. But this academic, sporting a red vest and affecting a professorial manner reminiscent of an Oxford don, actually has a quarter of a century at the U.S. Federal Reserve behind his back.

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Who: Vincent Reinhart, Resident Scholar, American Enterprise InstituteWhere: Teatro Goldoni, 1909 K Street, Washington, D.C., November 19, 2007On the Menu: Tuscan bean soup, pan roasted Alaskan sable and the inner workings of monetary policymaking.

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During his last six years at the Fed, Reinhart played a dual role as Director of the Federal Reserve Board's Division of Monetary Affairs and Secretary and Economist to the Federal Open Market Committee. His job was to prepare monetary aggregates data and Fed surveys for the Board of Governors -- a key input in monetary policy decisions -- and to edit and disseminate the notes of the FOMC meetings, a crucial output from the Fed to the public.

While not directly involved in decision-making, it is hard to find someone with better knowledge of how U.S. monetary policy is made. Moreover, Reinhart's tenure, which began at the New York Fed in 1983 before continuing in D.C. in 1988, spanned not only the record-setting 18-year chairmanship of Alan Greenspan, but the second half of Paul Volcker's reign as well as the start of Ben Bernanke's.

It was, Reinhart admits, a great time to be at the Fed -- perhaps the best era for monetary policy ever. The back of inflation was broken just about when Reinhart got to the Fed with a graduate degree from Columbia University, and the subsequent two decades were marked by monetary stability, steady economic growth, wealth creation and the development of financial markets.

Better KnowledgeWhat was the secret of the Fed's success, especially compared to the failure of monetary policy during the 1970s? Were major mistakes made previously?

"It would be easy for me to admit that mistakes were made in the 1960s and 1970s," smiles Reinhart. "But it was a combination of factors, not just greater monetary discipline."

In particular, he credits the development of economic science and better understanding of how different parts of the economy fit together. Back then, the Fed wasn't making decisions on a whim. They were based upon what was then thought to be solid economic principles, such as a supposed link between unemployment and inflation. Bringing down inflation was thought to entail a politically costly rise in unemployment.

The deregulation of the financial services industry and remarkable growth in financial markets also helped keep the economy stable. There is now far better understanding of risk and enhanced techniques of risk management for market players. The fact that the market largely sets the price of money -- i.e., interest rates and exchange rates -- gives greater flexibility for the financial system. A free market reacts to developments gradually over time, not all at once as tightly regulated markets tend to do.

In this regard, Reinhart stresses the need for timely and clear communications by the Fed -- and not only because it was his job at the FOMC. Managing inflationary expectations in society is now seen as a key piece in keeping prices stable. The Fed has greatly expanded the quantity and quality of information it now delivers to the public.

"You should recall that a relatively short time ago the Fed never even announced its monetary policy decisions. Markets would guess what was decided by the FOMC by watching the Fed's market operations after the meeting."

Now, Bernanke has doubled the number of the Fed's annual economic forecasts to four. Reinhart believes that there will always be ambiguity in the Fed's communications, but they will concern such technical matters as points of market intervention, not broad policy decisions.

Plodding PaceCuriously, while the financial landscape has changed dramatically, the institutional side of decision-making remains the same as when the FOMC was created in the 1930s. The Committee still meets around eight times each year and has 19 places around the table. Just 12 are entitled to vote on monetary policy decisions, seven members of the Board of Governors and five representatives from the regional Federal Reserve banks.

By tradition, decisions have to be agreed upon by all voting members, and all participants are allowed to express their opinions. This tends to be time-consuming. Unlike the Bank of England, for example, whose decision-making body consists of nine members all of whom sit in the same place, members of the FOMC are dispersed all around the United States and only come together for the meetings. "This is why it takes three weeks for the Fed to publish its minutes, and just two weeks for the Bank of England," observes Reinhart.

However, the fact that Congress meant the FOMC to be so decentralized doesn't hamper monetary policy. "Monetary policy is set by the FOMC, but it is implemented through forward-looking financial markets," says Reinhart. "The FOMC doesn't have to meet whenever an economic statistic is released. Markets discount the Fed's reaction to economic data, so that when the Fed finally changes its interest rates, it in effect validates previous market moves."

Dual Objective Decentralization and collegial decision-making at the Fed are important advantages. FOMC minutes reflect genuine debate at the Committee and highlight concerns of individual members.

"Whenever issues arise that may eventually lead to policy changes, markets do not get blindsided. They can see well in advance that somebody on the FOMC is thinking about these matters."

Although Greenspan had the managerial skill to put before the Committee only the kinds of decisions that other members would be willing to make, his personality dominated the Fed during his long tenure. Chairman Bernanke, on the other hand, has been working to depersonalize decision-making at the FOMC and to bring its collegial aspects more to the fore, says Reinhart.

The Fed has another institutional constraint. Its mission, as defined in the Federal Reserve Act of 1913, is to "maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates."

In other words, the Fed needs not only to keep inflation low, but to make sure that the economy uses resources to full capacity.

"It's not an idle threat," says Reinhart. "Barney Frank gave an interview to the Financial Times when he became the Democratic Chairman of the House Financial Services Committee, promising to hold the Fed responsible for the full employment aspect of its mission."

Linear WorldUnemployment remains low in the current environment, but the labor market is a lagging indicator. The Fed has already come in for considerable criticism for its easy monetary policy early in this decade, which allegedly laid the foundations for the current subprime mortgage crisis.

"Bankers like to live in a linear world," counters Reinhart. "They dread non-linear events, such as when banks suddenly stop lending or when nominal interest rates go to zero and therefore can't be reduced in a crisis."

In a non-linear world, a policy mistake could be extremely costly. A rise in inflation, on the other hand, is a linear event. When in 2001-2003 inflation kept falling, threatening the economy with deflationary pressures, the Fed opted for continued monetary policy ease. It recognized that it could spur an uptick in inflation or an asset price bubble, but it was, Reinhart asserts, an insurance policy for keeping the economy in a linear world, a situation with which the Fed knows how to deal.

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Alexei Bayer runs KAFAN FX Information Services, an economic consulting firm in New York; reach him at abayer@kafanfx.com. His monthly "Global Economy" column in Research has received an excellence award from the New York State Society of Certified Public Accountants for the past four years, 2004-2007.

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