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The Fed Family Feud

Oil and interest rate policy don't mix.

12:00 AM, Jul 1, 2008 • By IRWIN M. STELZER
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LAST WEEK THE Federal Reserve Board's monetary policy committee (technically, the Federal Open Market Committee, or FOMC) decided to leave interest rates as they are. And thereby hangs a tale of oil, our chief bond salesman, the White House, and the Fed Family. What follows is a combination of hard fact and my own surmise, mixed together so as to shield highly placed sources.

The "Fed family" is not as shady as a Mafia family, but far more powerful. Its members include Chairman Ben Bernanke and the six other members of the Board of Governors, appointed by the president; the presidents of the 12 regional Fed banks, five of whom serve on the FOMC; and several influential alumni who are frequently consulted by Bernanke and the White House, and whose public utterances Bernanke cannot ignore.

In times like these, when recession looms, inflationary pressures are rising, and many banks are, er, teeter-tottering, many of the Family members weigh the several dangers differently. Some worry about rising employment, and want to keep interest rates low; some worry more about inflation, and want to raise rates; others worry about the health--or lack of it--of the banks, and favor the sort of open-handed policy that Bernanke has adopted to provide liquidity to the banks; still others worry that bank bail-outs will create moral hazard and produce even more reckless lending behaviour. Gone are the good old days when benign economic conditions led to virtual unanimity of views.

So far, so obvious. But two things are not so obvious. The first is the intensity of the battle within the Fed Family. That has an advantage: Bernanke benefits from a wide range of views, which he says he welcomes. The board of governors generally worries most about the soundness of the banking system. The presidents of the regional banks, selected by local businessmen and bankers, generally worry more about inflation than anything else, which is why the presidents of the Fed regional banks in St. Louis, Dallas, Kansas City, Boston and St. Louis have opposed recent rate cuts. The members of the FOMC worry about everything. And the alumni sit on the sidelines, sniping or supporting the chairman, depending on their view of each of his actions. Not a bad system, messy though it is.

Enter Hank Paulson, the Saudis, and the White House. Someone has to find customers for the billions in Treasury IOUs that result from our on-going federal budget deficits. That's Paulson's job, making him the nation's number one bond salesman. The Saudis are among his most important customers. But the decline in the value of the dollar is steadily reducing the value of the dollar-denominated bonds that they hold. So Paulson decided to go to Riyadh late in May to soothe some ruffled royal feathers. Reliable sources say that the Saudis "hinted, as is their style" that if the United States wants more oil, and if the United States wants the Saudis to continue pegging their currency, the riyal, to the dollar, America should do something to shore up the dollar.

Paulson brought that message back, got clearance from the White House, and issued a statement that America intends to stabilize the dollar. As the Left is wont to say, it is no coincidence that the Saudis announced several increases in oil production.
But the story doesn't end there.

The threat of an increase in interest rates upped the downward pressure on bank shares, as it made it more expensive for them to raise the new capital they desperately need. Bank shares plummeted. The members of the Fed family who worry most about the stability of the banking system saw meltdown in America's future, and decided to do something to help the banks even though some of the alumni were already mightily annoyed at the Fed's solicitude for banks that had lent recklessly.

Most vociferous has been William Poole, until recently head of the St. Louis Federal Reserve Bank and a member of the Fed's interest-rate setting committee. Dr. Poole has called the Bernanke-Paulson decision to take some of the banks' diciest loans onto its own balance sheet "appalling"; former senior staff member Vincent Reinhart called it "the worst mistake in a generation" according to the Washington Post. That can't be the point of view of Timothy Geithner, president of the New York Fed. Geithner sees what is going on in financial markets up close, and backed the decision to prevent the bankruptcy of Bear Sterns, which decision he was called from relative obscurity to defend before congressional committees. Which all observers, even those who think the Fed should have let Bear go under, agree he did rather well.