WASHINGTON -- Behind the Federal Reserve's decision last week to make no change in monetary policy were two momentous developments inside this most secretive government institution. First, Chairman Alan Greenspan, nearing the end of his protracted tenure, reasserted control after recent shaky performances. Second, an ideological struggle began inside the central bank that could influence the U.S. economy far into the future.
Greenspan's strength was seen in the Federal Open Market Committee's (FOMC) decision Oct. 27 to not only retain low short-term rates but keep them for a "considerable period" -- despite the desire of the Fed's influential staff to eliminate those two words. That also represented movement toward an "inflation standard" in determining monetary policy, diminishing power of future Fed chairmen and bureaucrats.
Although today's Federal Reserve is almost transparent when compared with its opaque past, what goes on behind closed doors in its marble palace remains cloaked in mystery. The events last week were especially shrouded by Greenspan's desire to avoid the impression of controversy in his final years and an important doctrinal debate between two remarkable new Fed governors.
These two governors both took office Aug. 5, 2002, ending years of humdrum appointments to the central bank that reflected Greenspan's wishes. One new governor was Ben Bernanke, the 48-year-old chairman of Princeton University's economics department and the most distinguished economic theorist on the Federal Reserve Board in recent memory. Bernanke was a rare Fed nomination originated in the White House, not by Greenspan. The other new governor was 59-year-old Donald Kohn, a Fed staffer for 35 years and Greenspan's right-hand man the last 15.
Bernanke has long advocated setting inflation targets to determine whether the central bank should tighten or loosen. Not wishing to offend Greenspan, the rookie governor has argued that this will help the next chairman, who would lack the magical finesse of "the maestro." An inflation standard would threaten the central bank's aura of mystery and its world-famous staff's actual power. Kohn, who did not become only the third member of the Fed's bureaucracy ever to be a governor just to preside over its diminution, opposes targeting inflation.
Bernanke vs. Kohn is no mere theoretical debate. Greenspan, blamed by Republicans for contributing to the first George Bush's 1992 defeat by tightening money, does not want to doom re-election chances of the second President Bush by snuffing out the recovery -- particularly after the president extended his tenure to 2006. Kohn and the Fed staff want to tighten whenever the economy grows -- the old Phillips Curve -- even if inflation continues to fall, as is now happening. A showdown was set for the FOMC meeting of Oct. 27.
On Oct. 23, Washington Post reporter John M. Berry wrote that Fed policymakers were not only going to retain the low 1 percent overnight rate but "are also likely" to repeat their September statement that rates would stay low for a "considerable period." What Berry writes is seen in financial circles as Greenspan gospel. However, a long article on the Oct. 27 front page of the Wall Street Journal by Greg Ip revealed strong opposition inside the FOMC to those two little words. That was seen as the voice of Governor Kohn and the Fed bureaucracy.
Money markets were in doubt. In July, Berry had signaled the FOMC would reduce the overnight rate by 50 basis points, down to .75 percent. But Ip reported the cut would be only 25 basis points -- reflecting the powerful Fed staff's caution. At the July meeting, Greenspan was passive and the staff prevailed. The results were temporarily devastating, with long-term interest rates rising and stock prices falling. To prevent calamitous long-term effects, Greenspan did not let history repeat itself in October. The "considerable period" statement, implicitly targeting inflation instead of growth, was retained. One veteran Fed-watcher called it "a manhood issue" for the chairman.
Beyond Greenspan's manhood and even George W. Bush's re-election lies America's economic future. No rookie Fed governor has ever been so ideologically adept as Kohn, who until now has kept under cover his theoretical dispute with Bernanke. Greenspan is reported to have no objection to targeting inflation, but only after he leaves the Fed. If this happens, there may never be another Greenspan -- a small price for a more stable economy.