Fed is bit player in global economy

July 02, 2008|By JAY HANCOCK

The business press paints the Federal Reserve as omnipotent. Maybe once it was. But events are likely to prove it has lost some of its mojo.

The nation's central bank controls a smaller piece of the global economy than in the last severe recession, in the early 1980s. And it no longer influences the price of oil as it once did.

Those seldom-acknowledged facts make its job more difficult, and the outcome of its efforts to fight inflation or keep the country out of a bad recession more uncertain.

The Fed directly influences only the U.S. economy and dollar-denominated investments overseas. But for a long time, this meant it pretty much controlled the global economy, and, by extension, the price of petroleum.

"America sniffles and the world gets double pneumonia" was the economic cliche for 40 years. The U.S. economy was comparatively so big - delivering a fourth of world output in the 1980s, after adjusting for currency swings - that it set the trend for the rest of the planet.

U.S. dominance was reinforced by its openness to trade while many countries walled off international commerce in miserable attempts at communist self-sufficiency.

Now, however, the world sets the course for America. The U.S. share of world output is down to about a fifth. Many nations - China, Brazil, Russia, India - are growing much faster than this country and will do so for decades.

Despite the hearty U.S. appetite for imports, this country's contribution to international trade has also fallen. (Our share of global imports has fallen to 15 percent, the lowest level since the early 1990s, while developing-nation imports have risen from less than 30 percent to 40 percent.)

That means Fed Chairman Ben Bernanke isn't in the driver's seat. He's in a little outrigger sidecar attached to, say, a Geely Free Cruiser - one of the hottest automobiles made in China.

In the 1980s, Fed Chairman Paul Volcker defeated inflation by raising short-term interest rates and pitching the country into a severe recession. This helped smother the global demand for oil and other commodities fueling the inflationary spiral, which paved the way for a prosperous recovery.

Now the United States is in a recession or very close to it, but global demand for energy shows no sign of diminishing. Demand from Brazil and China has driven oil above $140 a barrel even though American oil use is moderating.

By leaving short-term interest rates unchanged last week after a series of reductions, Bernanke was trying to put slight pressure on growth and inflation. But inflation may well ignore him, especially if concerns about war between Israel and Iran keep oil prices on the ascent.

The Fed doesn't even control as much of the U.S. economy as it used to, although this might change.

The Fed does its job by injecting or withdrawing money in American banks. This worked great when traditional banks were the only lenders, but bond markets have overshadowed other money sources during the past two decades.

The collapse of investment banking company Bear Stearns (a nontraditional lender) is the most sobering example of this. The Fed hasn't propped up investment banks for decades. But Bear's implosion forced it to intervene, and now Bernanke and Treasury Secretary Henry Paulson want to give the Fed new powers to catch up to other nontraditional lenders.

That, however, will take years to fully develop. The U.S. economy is at risk now.

During the last U.S. slump, the Fed cut its key federal funds rate to 1 percent, the lowest level in four decades. Did it cut that much because the recession was so severe? Not really. The slowdown was barely a recession by formal standards.

Instead, the Fed's diminished power these days is forcing it to greater extremes to try to get the desired results.

Its dilemma now is to focus on inflation or recession. If it raises rates to fight inflation, it risks squashing investment and boosting unemployment. If it cuts rates to spur growth, it risks letting inflation flare.

In either case, don't be surprised if the weapons prove wanting.

Electricity update

Illinois Attorney General Lisa Madigan withdrew her claim that certain generators operated by Edison Mission Energy were continuing a suspicious trading pattern Edison had claimed it stopped.

Reviewing data from PJM Interconnection, the grid from here to Illinois, Madigan had said plants that looked like Edison's were continuing the troublesome strategy that had the effect of withholding power and driving up prices.

New, more detailed PJM data show that the plants aren't Edison's, Madigan says in a new filing with the Federal Energy Regulatory Commission. But she contends that Edison still may be withholding power from the grid in some other fashion in an effort to influence prices - an allegation Edison denies.

"We stand by our prior statements that we act in compliance with PJM bidding rules," said Edison Mission spokesman Doug McFarlan.

And Madigan still wants FERC to reopen a case that previously examined Edison's suspicious trading patterns but ultimately made no finding about whether they were improper.

jay.hancock@baltsun.com

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