Friday, November 30, 2007

A Day in the Life of a Federal Reserve Chairman

Help Wanted: Chairman of the Federal Reserve Bank


  • Must be able to predict the future
  • Demonstrate the ability to perform a balancing act between the financial system, consumers, and the global economy
  • Strong communication skills – ability to speak in public a must

The job entitled Chairman of the Federal Reserve is a tough job. Here are some of the qualifications required out of a successful Chairman of the Federal Reserve Bank.

Must be able to predict the future

This skill is essential, but the most improbable; predicting the future is impossible. We can make our best efforts to estimate the probability of events, but that is about it. The Federal Reserve Bank uses large econometric models in order to predict the future, but even these models may be wrong. The Federal Reserve Chairman must be able to react to economic shocks that were not foreseen in order to maintain economic stability.

Demonstrate the ability to perform a balancing act between the financial system, consumers, and the global economy

Generally, policy is conducted with the notion that falling interest rates stimulate domestic economic growth. First, based on economic theory, lower interest rates stimulate consumption demand (because saving is worth less in the future) and investment in housing and business capital (cost to take out a loan falls). This is good for the economy, and growth results. Second, the financial markets like lower interest rates. How often do you read, “Fed announces a lower interest rate target, markets rally”? Lower interest rates mean a higher current value of lifetime profits for firms (see an Accounting text on this, but I certainly am not going to subject you to the equation). Demand for stocks rise, pushing up stock prices (portfolio value). Faced with nervous consumers and a weary financial system in the U.S., what should Ben Bernanke do? Well, financial markets expect falling interest rates to stimulate economic growth.

This is not the whole question.

The Fed Chairman must consider global economic variables as well. For example, the value of the U.S. dollar is fundamentally dependent on forces of supply and demand. I use two simple examples for illustration. As American demand for imports rises, the demand for foreign currency to pay for those imports rises, and the U.S. dollar falls in value. Also, if interest rates in the U.S. fall (the return on U.S. treasury bonds and notes), then the international demand for U.S. bonds falls, the demand for U.S. currency falls, which again reduces the value of the U.S. dollar. Now, faced with this information, what should Ben Bernanke do? Well, in order to stabilize the value of the U.S. dollar, perhaps an increase in interest rates is the proper course of action.

In the simple examples that I have just described, a strong and imminent policy quandary has evolved. As argued in the Economist, and myself of course, the Fed should consider the international repercussions of reducing interest rates since a global economic disaster would result. Thus, policy should look to stabilizing the dollar, rather than appeasing financial markets.

Strong Communication Skills – ability to speak in public a must

A Fed Chairman’s policies are only as good as the public (consumers, firms, and the globe) believes the Fed Chairman to be. When Ben Bernanke spoke about “headwinds for the consumer in months ahead,” in a speech last Thursday, he was strategically signaling to the public that a reduction in interest rates, or an expansionary policy, may occur. He is saying that the Fed understands the economy’s current distress, and that the Fed is considering helping it along. This announcement alone (without any such policy action) can stimulate financial markets, consumer spending, and bank loans if the announcement is credible.

So, how will the current Chair, Ben Bernanke, fare in this so-called troubled economy (see related post, U.S. Economic Outlook)? Only time will tell. He is the 14th Chair and assumed office just two years ago (February 1, 2006). The economic outcome of monetary policy is so lagged (you don’t see the effects for a long time) that we may not know of his successes/failures for years. Some economists now blame Alan Greenspan, 13th Chairman of the Federal Reserve, for the current housing slump since he allowed too much liquidity to remain in the U.S. economy for too long.

Do you have any thoughts? I welcome your comments. Best, Nonthruths

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