By Mel Duvall  |  Posted 2005-04-06 Print this article Print

How does Federal Reserve chairman Alan Greenspan decide to raise rates a quarter point? By analyzing a potent mixture of raw pecuniary data and computerized economic intelligence against first-hand reports from key hubs of U.S. financial activity and five

Uncommon Senses

Congress created the Federal Reserve in 1913 as a fail-safe bank to the banks. Its job was to accept other banks' deposits, make overnight loans to them and issue coin and currency. Today, it also processes 18 billion inter-bank checks each year.

Its most public role—Greenspan's role—is to set monetary policy.

The chairman regulates the supply and price of money to achieve three primary goals: maximize economic growth, advance employment and control inflation.

To achieve those objectives, he has a powerful set of tools. For starters, he can raise or lower interest rates, by ripple effect, throughout the country by adjusting either the Federal Funds Rate or the Discount Rate.

The Federal Funds Rate is the price commercial banks charge each other to borrow federal money overnight. The Discount Rate is the price the 12 reserve banks charge commercial banks to borrow funds on a daily basis.

By directive, Greenspan also can increase or decrease the amount of money banks lend by raising or lowering the amount of money they are required to hold in reserve against outstanding loans and investments, something known as the "reserve requirement." In effect, if a bank is required to hold $20 of each $100 it receives in a deposit, it can lend 80% of its deposits. If it must hold only $10, it can lend $90, which increases the amount of money in use.

Separately, Greenspan can manipulate the supply of money in the economy by selling or buying government securities such as Treasury bills.

Greenspan decides which tools to wield from an elaborate two-story boardroom in the center of the Federal Reserve building on Washington's Constitution Avenue.

On meeting mornings, like Feb. 1, Greenspan enters this room from his attached office and seats himself at the side of the 27-foot mahogany table. He prefers to be seen as participating in the discussion rather than leading it.

Still, attendees know who is in charge.

Greenspan arrives at these meetings with his mind largely made up, according to Laurence Meyer, vice chairman of private forecasting firm Macroeconomic Advisers and a Fed governor from 1996 to 2002.

The chairman knows what he wants to do, such as raise the Funds Rate, and has already drafted the statement the Fed will issue after the meeting.

Greenspan is guided by the advice of six governors, named to 14-year terms by the presiding U.S. president. The governors and the 12 reserve bank presidents each get an opportunity to speak, usually for about five minutes. But unless the majority strongly disagrees with the chairman's views, Greenspan's plan will be approved.

Meyer says Fed board members do debate. But the assumption is that everyone will vote with Greenspan at the end of the meeting. Perceived dissension at the Fed could shake confidence and set off financial-market chaos, he explains. A split vote would cause uncertainty in the markets about exactly where the Fed was headed—to higher or lower rates.

"The committee doesn't want to fracture consensus," he says. "You never like to surprise markets."

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Indeed, the Fed chairman does not give interviews, fearing his words could affect stock markets worldwide.

Greenspan has spent years in and out of government searching for ways to eliminate economic surprises.

He previously served as economic adviser to Presidents Nixon and Ford, but had made his mark in the business world by providing economic forecasts to paying corporate clients, like Republic Steel (since merged into LTV Steel).

At the firm of Townsend-Greenspan, the tenor-saxophone-playing New York University Ph.D. economist had become particularly adept at forecasting demand and prices for steel and raw materials, like iron ore and coke, involved in its production. He accurately forecast a glut of steel production in 1957, by comparing steelmaking capacity against consumption patterns. His advice allowed clients to escape some of the turmoil that hit the industry in 1958, when steelmakers were forced to curb production 20%.

Contributing Editor
Mel Duvall is a veteran business and technology journalist, having written for a variety of daily newspapers and magazines for 17 years. Most recently he was the Business Commerce Editor for Interactive Week, and previously served as a senior business writer for The Financial Post.


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