Approaching Nothing

Approaching Nothing

Ben Bernanke's emergency 'war

powers' authority has undermined

the Fed bank presidents.

federal reserve by Craig Torres and Steve Matthews | Bloomberg News

The Federal Reserve's interest-rate target is getting close to zero, and so is the power of the Fed's regional bank presidents.

The district chiefs' authority over borrowing costs has been marginalized in the past two months as Chairman Ben S. Bernanke and the Fed Board of Governors in Washington made their own decisions on emergency measures to flood the economy with cash.

"The Board has usurped authority," says William Poole, former president of the St. Louis Fed and now a senior fellow at the Cato Institute in Washington. "This dramatic change in policy direction has not been announced or even acknowledged."

Bernanke must now try to bring the Federal Open Market Committee, which includes district presidents and Fed governors, along as he turns to more radical strategies, such as buying Treasuries to drive down long-term rates. A lack of consensus at next week's FOMC meeting could result in muddled communication that confuses investors and undermines confidence.

"Whatever our communications problems are now, they are going to be magnified in this new world we are going to be in," James Bullard, Poole's successor at the St. Louis Fed, says. "We have a bunch of analysis in the works right now. Frankly, I am mulling it over myself."

Yields on 10-year Treasuries this month slid to the lowest level since at least 1962, in anticipation of Fed purchases and weaker growth. The notes yielded 2.73% recently New York, compared with an average of 4.70% in the past decade.

Forgoing a vote

A conference call last month showed how little say the central bank's 12 regional presidents now have in some of the Fed's biggest decisions.

The regional bank chiefs were invited to listen as officials in Washington outlined their decision on a new $600 billion program to help the housing market.

The presidents weren't asked to vote on the initiative, even though it aimed at cutting borrowing costs, something they vote on in regular FOMC meetings.

"If I am a regional Fed bank president, I have had my power diminished a lot," says Ethan Harris, co-head of U.S. economic research at Barclays Capital Inc. in New York, who used to work at the New York Fed. "I think of it as war powers for the Board of Governors."

Many of the new facilities have been studied and recommended by the New York Fed, whose president, Timothy Geithner, is the vice chairman of the FOMC.

Geithner, President-elect Barack Obama's nominee to be Treasury secretary, is leaving the FOMC and will be replaced by Christine Cumming, the New York Fed's first vice president.

Emergency powers

Regional bank presidents don't have a vote when the Board uses emergency powers to lend to firms other than banks in "unusual and exigent circumstances," as it's done repeatedly this year.

The district-bank chiefs by design are supposed to offer a counterbalance to the Board, and in the past haven't been shy about challenging chairmen.

In February 1994, former Chairman Alan Greenspan had to argue against four presidents who wanted to raise rates at least a half percentage point, compared with his own preference for a quarter-point move.

Greenspan worried about the effect on markets of an abrupt move, transcripts of FOMC discussions showed. He says he "also would be concerned if this committee were not in concert. If we are perceived to be split on an issue as significant as this, I think we're risking some very serious problems in this organization."

The Fed has deployed two main strategies during the current credit crisis. The FOMC, which currently includes five governors and five presidents, has lowered its benchmark federal funds rate target by 4.25 percentage points since September 2007.

Acting separately, the Board of Governors has provided emergency funding to gridlocked markets and troubled institutions such as American International Group Inc. that were on the brink of failure. Those actions have made the key rate less relevant as a tool of policy, because they've driven down the overnight lending rate between banks below the target set by the FOMC.

While the target is 1%, the effective federal funds rate averaged 0.33 percentage point in the past week.

"The federal funds rate is trading persistently below target," says Poole, who is a contributor to Bloomberg News. "That can't be an accident."

With its new $600 billion program, the Fed has stepped out of its traditional role of backstop liquidity provider, making a direct effort to manipulate long-term mortgage rates. Some presidents are wary of any strategy that appears to subsidize debtors by pushing rates below yields set by the market.

Allocating credit

"Central bank lending policies should avoid straying into the realm of allocating credit across firms or sectors of the economy," Philadelphia Fed President Charles Plosser said Dec. 2.

Richmond Fed President Jeffrey Lacker warned last week that officials should avoid any plan that would have the central bank pay for a fiscal stimulus.

Obama has put an economic recovery program at the top of his agenda when he takes office Jan. 20. Lawmakers in Congress have suggested that the size of such a program may be between $500 billion and $700 billion.

"I personally do not believe the Fed should tie asset purchases to any specific fiscal programs, whatever their merits," Lacker said after a speech in Charlotte, N.C., Dec. 3. At the same time, he says he was open to purchasing U.S. government debt for the purpose of fighting the danger of deflation.

At next week's meeting, Board officials will likely propose ways to lower longer-term interest rates so mortgage and corporate borrowers can borrow more cheaply.

Bernanke said in a Dec. 1 speech the Fed could purchase Treasury or agency securities in "substantial quantities." District presidents may simply be asked to support and expand on what the Board has already done.

"The Board's importance has grown at the expense of the FOMC," says Dino Kos, former markets director at the New York Fed and now managing director of research firm Portales Partners LLC. "The FOMC meeting itself is going to become a very uncomfortable place if people don't know what they are there for. Institutional issues are at stake."