When the Fed Took Orders from Treasury


By Mike Brewster To support Federal Reserve Board Chairman Alan Greenspan's and his 11 Federal Open Market Committee colleagues' decision on Sept. 16 to keep the federal funds rate steady at 1%, they noted that "spending is firming, although the labor market is weakening." Their statement gave currency to the idea that the nation's 6.1% unemployment rate might keep the Fed from bumping interest rates back up for the rest of the year -- and possibly through 2004's Presidential election.

Chronicling the wisdom and trying to read the motives of the legendary Greenspan, whose fourth term as chairman of the Fed's Board of Governors expires next June 20, has become a cottage industry in financial circles. In the days leading up to the June 25 meeting on June 25, for example, investors and the financial press speculated that the central bank might try to spur growth by cutting the federal funds rate by half a percentage point. When it instead cited "markedly improved financial conditions" and reduced the rate by just a quarter-point, to 1% (the 13th cut during George W. Bush's Presidency, to the lowest level since 1958), investors wondered if the Fed wasn't being aggressive enough (the jury is still out on that).

EARLY CLEARANCE. The drama surrounding what the Federal Reserve would decide on interest rates hasn't always been so extreme, however. After its creation as the country's central bank by The Federal Reserve Board Act of 1913, the Fed spent the next 40 years exercising its tremendous power over the economy in concert with the U.S. Treasury, typically clearing its interest rate adjustments with the Treasury Secretary weeks ahead of time. When Treasury wanted the Fed to buy U.S. government bonds, it did. When it wanted to the Fed to slash the overnight lending rate, it did.

Beginning in the 1940s, however, the idea began to spread that interest rates should reflect economic conditions and not be changed artificially, as it were, by the Treasury and the Fed. As William McChesney Martin Jr., then-chairman of the Fed, put it in an address to the Economic Club of Detroit in 1953, the nation had to build a bridge from the "officially supported market of the war" to one more reflective of a peacetime economy.

In March, 1951, during Harry S. Truman's Presidency, the Treasury and the Federal Reserve reached an accord that declared the Fed an independent entity that should be free from executive branch meddling. Not everyone liked this change -- including Prescott Bush, a Republican senator from Connecticut and the grandfather of George W. Bush.

"DELIBERATE PLOT." A little more than 50 years ago, Prescott Bush addressed the annual luncheon of the Bond Club of New York on the evils of a Federal Reserve that was free to set rates as it saw fit. Senator Bush, a former partner at investment bank Brown Brothers Harriman, feared that the Fed might be tempted to establish its newfound independence by bumping rates up -- the better to slow economic growth and play havoc with the year-old Republican Administration of President Dwight D. Eisenhower. He imagined a "deliberate Wall Street-Washington plot to raise interest rates, drive down bond prices, and squeeze the little man."

Bush needn't have worried. Throughout the early 1950s, rates remained relatively stable, and the Fed solidified its nonpartisan reputation and fueled an uninterrupted period of post-World War II economic growth. The legitimacy of an independent Federal Reserve got its first real test in 1956, when President Eisenhower's Treasury Secretary, George Humphrey, and his top economic adviser, Arthur Burns, wanted to thwart the Fed's plan to raise the interest rate it charged its member banks from 2.5% to 2.75%.

The confrontation had the makings of an historic economic showdown, until Eisenhower stepped in and said the Fed was free to set rates. He noted that he was sure "if money gets to what is normally referred to as tight, [the Fed] will move in the other direction in some way or other as soon as it can."

Considering that it was an election year, Eisenhower showed unusual courage in supporting a policy that, according to the theory of Prescott Bush, could have slowed the economy and hampered his bid for a second term. The current President Bush can't complain that the Fed's actions have hurt his quest to get reelected. Which, once again, proves the wisdom of divorcing the Fed from politics, and letting it focus on the economy. Brewster is author of Unaccountable: How the Accounting Profession Forfeited A Public Trust (April, 2003) and is co-author of King of Capital: Sandy Weill and the Making of Citigroup (June, 2002)


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