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Why Wall Street doesn't understand the Fed

By Neil Irwin

For those of us who follow the Federal Reserve closely, it is sometimes shocking how poorly Wall Street seems to understand the central bank. The rumor Tuesday was that Ben Bernanke would, at his monetary policy testimony Wednesday, announce that the Fed is cutting its interest rate on excess bank reserves, now at a quarter percentage point, to zero.

This speculation, apparently, drove the stock market up in late trading. Yet it's completely blinkered. A few observations:

First, the rumor as reported doesn't make any sense to anyone familiar with how the Fed makes policy announcements. I am not aware of a single historical instance in which the Fed chairman announced an interest rate decision in congressional testimony. First, it would be a decision of the entire Federal Open Market Committee, not the chairman alone. Second, such announcements are made through a written communiqué, not to Congress.

Second, the timing is premature. I first wrote about the possibility of a cut in the IOER rate, as it is known in shorthand, two weeks ago. But as I wrote then, the majority of Fed policymakers still believes that the recovery is on track and that no such policy move is needed at this stage. The economic data and financial market results since I wrote that article have been mixed--certainly not weak enough to suggest that previously reluctant policymakers would have come around to new action.

Third, Bernanke has made clear that he is averse to taking emergency policy actions between FOMC meetings. Whatever is going on now is clearly not the kind of emergency crisis situation that would warrant moving before the Aug. 10 meeting of the policy committee.

So what is real? Bernanke will very likely tell the Senate Banking Committee on Wednesday that cutting that interest rate is one of a handful of options that the Fed is evaluating should the economic recovery continue to stumble. The others, as I wrote two weeks ago, are strengthening its promise to keep interest rates low for an extended period and buying enough mortgage securities to replace those that mature. He will indicate openness to buying more long-term assets, but only if the economy appears to be heading back toward recession.

It is true that merely acknowledging these possibilities is a step on the way toward taking them, and if economic data come in weak over the next few weeks, action at the Aug. 10 meeting is not out of the question. But don't get your hopes up for action on Wednesday, traders.

Update: 9:55 a.m.
A source reminds me that decisions on interest on excess reserves are technically made by the Fed's the Board of Governors, not the somewhat broader Federal Open Market Committee (the latter includes presidents of regional Fed banks around the country, not just the seven governors based in Washington). Still, Bernanke has made clear that because decisions around that interest rate are part of setting monetary policy, he will involve the entire committee in the conversation, and my points about the unlikelihood of any new action Wednesday stand. With all the various policy tools the Fed has used (and may continue using) over the past two years, there will be no shortage of confusion going forward on which committee controls what tools. In short: the FOMC is in charge of the federal funds rate and the purchase or sale of long-term assets like Treasury bonds and mortgage backed securities. The Board of Governors controls the discount rate, interest on excess reserves, and any action that involves the emergency authority known as 13(3).

By Neil Irwin  |  July 20, 2010; 5:45 PM ET
Categories:  Federal Reserve  
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