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How powerful is the Federal Reserve?

With the chairman’s seat at the central bank expected to turn over to Ben Bernanke in January, it’s time for a reality check. Just how powerful is the Fed?
/ Source: The Associated Press

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 super powers unwisely, if it goes too far, it could push the economy into recession with just 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, the capital of Moneyland, with Greenspan as its ruler and resident hard-to-understand genius.

With the chairman’s seat at the central bank expected to turn 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. It’s 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 the rapt attention a parent gives a small child who is playing close to the street.

“We have said it before, and we shall say it again: The key to next year’s economic and financial market performance hinges upon the Fed not overreacting to the perceived inflation threat,” a recent Merrill Lynch research report said.

When the Fed released notes Tuesday 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 in Wednesday’s Wall Street Journal.

Wrote Stephen Wood, portfolio strategist at 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’s chief global equity 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 last 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.

This is nonsense, said Sandy Lincoln, chief market strategist at Wayne Hummer Asset Management in Chicago.

There are factors that are far beyond the Fed’s control, Lincoln said, such as the introduction of the euro, the globalization of the economy and the current sharp 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.”

For instance, former Fed chairman Paul Volcker hiked rates “to a fare-thee-well” after inflation spiked in 1981, Lincoln said. Greenspan acted decisively after the Black Monday market crash in 1987. The Fed reassured investors the day after Black Monday by saying it would serve as a source of liquidity. The president of the New York Fed, E. Gerald Corrigan, persuaded banks and securities firms to continue to extend credit and settle trades.

Most people haven’t heard of Corrigan, who left the New York Fed in 1993, after 25 years with the Federal Reserve system, but he played a key role in saving the day.

“We’ve attributed all kinds of powers to the Fed chairman,” Krosby said, but the Fed works as a team and the team today “is very experienced. Not just the chairman, but the governors and the staff.”

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. “It was like war time,” Krosby said.

What the Fed is trying to do is take the air out of the housing bubble, slow down the larger economy and see employment edge slightly lower.

“The key is a slowdown, not a crash,” she 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 super powers don’t necessarily think the Fed is 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 of 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.