Personal Finance

Learn More About the Fed and Alan Greenspan

By Brenda Watson Newmann
Senior Editor

When Alan Greenspan talks, investors listen -and they listen hard, because a few words from the nation's top economist can cause stock prices to rise or fall.

The bespectacled man wearing a conservative suit has been called the most powerful man in America. He has influenced the course of the economy since 1987, when he was first appointed Chairman of the Board of Governors of the Federal Reserve System - or Chairman of the Fed, for short.

Whether he is warning about "irrational exuberance" of the stock market or hinting that interest rates might change, Greenspan is frequently the center of economic attention.

At times, Greenspan's statements are couched in language so obscure that even professional investors don't know what he is trying to say. Leaving his remarks open to interpretation often seems to be Greenspan's way of making market reactions less drastic.

He does have to weigh his words carefully. His testimony before Congress in July 1998, when he said he was more concerned about inflationary tendencies in the US economy than about the possible dampening effects of the international financial crisis, caused stock prices to plummet. Why? Because investors assumed he would raise interest rates to stave off inflation, and when interest rates go up stock prices tend to fall.

As one long-time stock market observer said, "Greenspan often tries to issue a friendly warning, or an alert, to cause a healthy correction in the stock market so it doesn't get overheated."

In the end, Greenspan's hint of possible action may have eliminated the need to carry such action out. In fact, the stock market dropped so much over the following months that the Fed ended up lowering interest rates three times during the autumn, to stabilize the situation.

The 73-year-old Greenspan, a native New Yorker, is a highly trained and respected economist who does not follow any one economic doctrine. He has been praised for his belief that the US economy can best be analyzed and guided using a mix of theories. He considers inflation to be the US economy's worst enemy.

As Chairman of the Fed, his interpretations carry great weight at board meetings. When decisions are made, Greenspan is the last to vote, giving him tie-breaking power.

But sometimes, it's not easy being Greenspan.

Critics have said his crusade to control inflation has made Greenspan keep a too-tight lid on the economy. Also, presidents of at least two of the 12 regional Reserve Banks reportedly disagree with some of Greenspan's views and have challenged him at meetings.

Also, while the Fed is nominally independent from the government, it must still work within the constraints of government economic policies.

Greenspan has been appointed Chairman of the Fed by three consecutive presidents: Reagan, Bush and Clinton. His current four-year term expires June 20, 2000. Whether he will be reappointed again is anybody's guess, but he does seem to have convinced a lot of people that nobody can do the job better.

Treasury Secretary Robert Rubin, who recently announced his resignation, has been mentioned as a possible candidate to succeed Greenspan.

In any case, it is clear that Greenspan has become something of a popular icon. His 1996 remark about "irrational exuberance" - referring to overzealous stock market investors - has gone down in the annals of pop phraseology. There's even an Unofficial Greenspan Fan Club on the Internet. It's slogan? "Get exuberant!"

Explaining The Federal Reserve System

The Federal Reserve System is the central bank of the United States and the guardian of the US economy's well being. Its goal is to keep unemployment low, prices stable, and interest rates not too high and not too low. It does this by conducting monetary policy: that is, influencing the amount of available money and credit in the US economy, through its control of bank reserves. (The Fed is where banks do their banking.)

Congress created the Fed back in 1913, in response to the periodic financial crises that had been plaguing the US economy. In addition to carrying out US monetary policy, the Fed's duties include keeping an eye on banking institutions, maintaining stability in financial markets (stocks and bonds), and performing some financial services for the US government and foreign official institutions.

The main actors in the Fed are the seven-member Board of Governors, headed by Alan Greenspan, based in Washington DC, and 12 regional Reserve Banks in major cities around the country. They meet frequently to determine where the economy is headed. The Fed chairman is required by law to report to Congress twice a year.

The Federal Open Market Committee, which announced the bias change on Tuesday, is a 12-member committee that meets about every six weeks. It comprises the seven members of the Board of Governors and the president of the Federal Reserve Bank of New York, with the four remaining seats filled on a rotating basis by the presidents of the other 11 Reserve Banks.

The main thing to remember about the Fed is that it has the authority to raise or lower interest rates, which causes movement in the economy. In general, if inflation threatens, the Fed might want to raise interest rates to dampen it, and if an economic downturn seems imminent, it could decide to lower them.

How an Interest Rate Change Affects the Economy

When interest rates go up, it becomes more expensive to borrow money, and there is more incentive for consumers to put their money in interest-bearing accounts, so they tend to spend less. This causes prices to fall because there is less demand for products. In this way, inflation is thwarted.

From a company's point of view, however, higher interest rates mean lower profits. This is because the company's costs increase (interest it has to pay on loans to finance its activities) and its revenue decreases (demand for its products is down). When a company's earnings decrease, its stock value does too, because lower earnings mean lower dividends are paid out to the shareholder.

Conversely, when the Fed lowers interest rates, it has the opposite effect on the economy.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan. is the premier online community resource for 401(k) participants

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