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New leadership and new challenges at the Federal Reserve

Laurence Kotlikoff on the bad news that the financial community has yet to learn

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Laurence Kotlikoff

When it comes to the pocketbooks of ordinary Americans, few individuals can have more of an impact than the chairman of the Federal Reserve Board. Last week, Ben Bernanke, who led the President’s Council of Economic Advisers and was a longtime professor of economics at Princeton University, took over the post from Alan Greenspan, who had been chairman for more than 18 years.

Among other powers, the Fed adjusts the interest rate banks charge for loans to one another, known as the federal funds rate. This affects the interest banks charge consumers who borrow money for reasons ranging from starting a business to purchasing a home. Generally, raising interest rates tightens up credit, putting a brake on both economic growth and inflation, whereas lowering interest rates tends to spur both the economy and inflation.

For some insights on what we can expect from the Fed under Bernanke’s leadership, BU Today turned to Laurence Kotlikoff, a College of Arts and Sciences professor of economics, a research associate at the National Bureau of Economic Research, and the coauthor of The Coming Generational Storm: What You Need to Know about America’s Economic Future (2004). The book warns of an impending crisis from shortfalls in Social Security and Medicare funding, two of the fiscal storms through which Kotlikoff believes the Fed chairman will have to navigate the economy in the years ahead.

BU Today: Could you give us a nutshell explanation of what the Federal Reserve Board does?

Kotlikoff: The Federal Reserve Board determines the nation’s money supply. When it wants to increase the money supply, it effectively prints money and uses it to buy up bonds selling in the market.…When the Fed wants to reduce the money supply, it sells bonds in the market. The money it gets in exchange for the bonds is now in the Fed’s hands and is no longer circulating in the economy. By controlling the amount of money in the economy, the Fed can affect the level of prices and the change in prices over time — inflation. The Fed’s purchase and sale of bonds affects the price of bonds and the interest rate paid on bonds. So the Fed is often described as setting the interest rate or at least the short-term interest rate, since it mostly buys and sells short-term bonds in what’s called the federal funds market.

What will be the biggest economic challenges Bernanke will face as Fed chairman?

The government, on a long-term basis, is essentially bankrupt. When the financial community wakes up to this reality, which could be tomorrow, they will realize that our government can meet its bills in the long run only by printing money, which means inflation, higher interest rates, and lower bonds prices. Once the financial community starts worrying about bond prices declining, they’ll try to protect themselves by selling off their bonds. This, of course, will lower bond prices and raise interest rates.

Bernanke will be forced to intervene to keep rates low, but doing so means printing money to buy bonds — precisely what the market will come to fear. So Bernanke is going to face a major challenge that will in large part be out of his control.

How might Bernanke’s chairmanship differ from Greenspan’s?

Well I hope that Bernanke will be much more aggressive in pushing the president and Congress to make the tremendous fiscal reforms needed to keep our government solvent in light of the baby boomers’ imminent retirement. I have a coauthored article called “The New New Deal” [published in The New Republic, August 15, 2005] that discusses what we should do.

Last week, on the final day of Greenspan’s tenure as chairman, the Fed raised the federal funds rate for the 14th consecutive time since June 2004. When Bernanke chairs his first meeting of the Fed on March 28, would you expect another rate raise?

I don’t expect any more rate hikes. The rate is now 4.5 percent. With inflation at roughly 3 percent, this implies a real short-term interest rate of 1.5 percent, which is high by historical standards.

In addition to the Fed chairman having a direct influence on interest rates and money supply, when he speaks about the economy, America listens. How do you think Bernanke will handle this aspect of his position?

Bernanke is as smart as they get. He has a much better handle on economics and economic theory than Alan Greenspan. So he’s in a much better position to educate the American public on a range of economic issues.