Jeremy Siegel, Ph.D. The Future for Investors

The argument that the Fed is losing its ability to control the economy goes something like this:

• The flows of capital, especially coming from the Asian nations, are now so great that they overwhelm the ability of the central bank to control interest rates;
  
• In addition, money itself is changing as debit and credit cards are replacing Federal Reserve notes and checking accounts as the money of choice; and
  
• So much credit is available that the money the Fed controls no longer constrains the economy as it once did.

If the Fed is losing power over our economy, it would be an ominous development, indeed. The financial community has long counted on the Fed to bail the economy out of crisis and keep things humming. The Fed did its job after 9/11, and it dutifully picked up the pieces after Long-Term Capital Management, a hedge fund run by some of Wall Street's "best and brightest," collapsed in 1998 threatening the stability of the financial markets. If the central bank can no longer manage these crises, then the world economy is in for a much rougher ride.

That said, I'm not entirely convinced the Fed is weakening.

The Truth About the Fed's Power

Even though it's true that central banks no longer have as many policy levers as they did in the past, the demand for Federal Reserve Notes -- the one asset the Fed still has complete control over -- is huge.

The latest count of Federal Reserve Notes outstanding is $716 billion, which comes to more than $2,000 per person. Even if two-thirds of this cash is held outside the U.S., as some estimate, that still leaves about $700 of U.S. currency per person in this country.

Why is there so much cash? Federal Reserve notes are still very popular because they have a special quality that no credit or debit card can possibly have: They are traceless. There is no record of who owns them or who gives them to whom. How many other assets can you name that don't require your Social Security or Tax ID number?

The Buck Stops With the Fed

The Federal Reserve derives its enormous power through control of these notes, which the Fed prints and which banks hold as reserves. These reserves provide cash for the banks' customers and are the source of clearing balances that banks keep at the Fed in order to process checks.

Bank reserves are bought and sold in a market called the Federal Funds Market, and the interest rate determined in that market is called the federal funds rate. That is the rate that the Federal Open Market Committee sets when it meets in Washington about once every six weeks.

Because the Federal Reserve controls the quantity of reserves through the notes that it prints, it has complete control over the federal funds rate. If the Fed prints more notes, the supply of reserves goes up and the funds rate falls. If the Fed restricts these reserves, the rate goes up. The Fed has raised the federal funds rate from 1 percent to 4 percent over the last 18 months and will most likely raise it again to 4.25 percent on December 13, 2005.

The control of this key short-term rate has a strong impact on the economy. The federal funds rate is the controlling interest rate for all short-term credit, especially the prime rate. The prime rate is the basis for many consumer and home equity loans and is set by banks at three percentage points over the fed funds rate.

Furthermore, these rates strongly influence the rates on adjustable rate mortgages and commercial paper, which is short-term credit extended to businesses. By raising these rates, the Fed can slow spending. By lowering them, it can stimulate economic activity.

The Bottom Line

I admit there are many things that the central bank cannot control. But it directly controls the ultimate source of liquidity: Federal Reserve Notes. This control gives the Fed a free hand to set the cost of short-term credit. This is all the power the central bank needs to control spending and keep the economy stable. The Federal Reserve is no less powerful today than when Alan Greenspan took over the chairmanship nearly two decades ago and the responsibilities of central banker are as important now as they have ever been.