Robert Novak

WASHINGTON -- This question circulated for weeks in financial circles: Who will be Federal Reserve Chairman Alan Greenspan's "enforcer" when William McDonough is gone? The answer is nobody. That became clear June 25 as the Federal Open Market Committee (FOMC) met without McDonough, retired as president of the New York Federal Reserve Bank. Prudent Fed-watchers called the result a "disaster" -- posing a threat to President Bush's re-election.

Greenspan had prepared Wall Street for a reduction in the federal funds (inter-bank lending) rate from 1.25 percent to .75 percent -- dropping 50 basis points. Instead, the FOMC astounded the financial world by cutting half that much -- 25 basis points, down to 1 percent. Without McDonough's presence, a passive Greenspan submitted to the powerful Fed staff. The immediate consequences were opposite to what the central bank intended. The stock market fell and long-term interest rates rose.

Longer-term consequences could be far worse. With the Federal Reserve's credibility shattered, investors might fear future central bank tightening. Higher bond rates discourage corporate investment, which has not responded vigorously to the Bush tax cuts. That foretells continuing low growth of 2.5 to 3 percent, and continued loss of jobs. Those prospects should terrify the president's re-election team.

Greenspan, the most widely celebrated central banker ever, had disappeared the past year in mute confirmation of his inability to alter the economy. In recent weeks, however, admirers saw the old Greenspan at work. He deftly, if belatedly, issued deflation warnings. While pledging not to tighten the moment the economy shows signs of life, he signaled a big interest rate cut in store June 25. "Alan is back!" was the happy exclamation on Wall Street.

Sophisticated investors relied most on what they read in the June 19 Washington Post written by John M. Berry, the premier reporter covering the Fed. He said a 50-basis point cut "seems to be more likely" than 25 basis points. Such is Berry's reputation that this forecast was taken as the authentic voice of the chairman.

There is no way to know exactly what happened June 25 inside the FOMC, which meets secretly and does not keep verbatim minutes. Since then, Fed governors have been even more reclusive than usual. What is known is that the central bank's staff was opposed to the bigger cut, fearing how a .75 percent rate would force them into "non-traditional" monetary operations. Their hand was strengthened by installation as a new Fed governor last August of Donald L. Kohn, who had spent the previous 32 years on the Fed's staff.

Robert Novak

Robert Novak (1931-2009) was a syndicated columnist and editor of the Evans-Novak Political Report.

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