The Fed Learns That No Central Bank Is an Island

WASHINGTON —  It was just last summer--a long-ago era in today’s turbulent global economy--that Federal Reserve Board Chairman Alan Greenspan proclaimed he was more worried that inflation would reemerge at home than that foreign woes would drag the U.S. economy down.

Yet on Tuesday, the U.S. central bank cut interest rates in an effort to prevent the very downturn Greenspan had earlier discounted. The policy reversal only underlined the agonizing new calculations the Fed must make in a world where far-off financial turmoil threatens the U.S. economy, and where the Fed must compute not only the direct impact of its policies at home but also their indirect impact overseas.

“The role Greenspan is playing is global central banker now, and that’s an extremely difficult role--even for the largest country in the world,” said David M. Jones, chief economist at the Aubrey G. Lanston investment firm in New York.

In any formal sense, such a role would be completely unacceptable to most of the world. It suggests revolutionary notions of a global currency and painful incursions into national sovereignty.

For its own part, the Fed is clinging to its domestic charter--fostering U.S. economic growth with stable prices. Greenspan regularly alludes to this priority in his public remarks.

Nonetheless, in a time of a greatly weakened White House, inward-looking Europe and recession-weary Japan, the Fed is, as one analyst put it, “the only game in town.”

The game is fraught with new perils. More than ever before, globalized financial markets and burgeoning trade volumes between nations mean that U.S. policy miscues can backfire internationally, affecting currencies, inflation and unemployment at home and elsewhere.

From the Fed’s marbled fortress in Washington, the challenge of projecting how far woes from overseas could spread inside the United States requires a host of global, political calculations: What will the impact be on Latin America if the International Monetary Fund unveils a successful aid plan for beleaguered Brazil? Will Japan finally implement effective policies for its battered economy? With Germany about to install a new chancellor, what will be the course of European interest rates?

If the Fed cuts rates too soon, it risks unleashing the sort of speculative investment that quickly leads to inflation, said Stephen S. Roach, chief economist at the Morgan Stanley Dean Witter investment firm.

But if it moves too slowly, he said, it will be unable to head off a downturn.

The dizzying calculus represents a sea change in world view for the Fed, a traditionally secretive if genteel institution created 85 years ago by Congress in an era when financial panics and a poorly regulated banking system were major domestic concerns.

The Fed’s domestic focus was reinforced 20 years ago by legislation that defined its mission in traditional economic terms: maximizing employment, keeping prices stable and maintaining moderate interest rates.

Although oil shocks, debt crises and wars have provided regular reminders that America’s financial health is not entirely sheltered from events overseas, the notion of a central bank for the world, with authority over national economies and sovereign currencies, remains a radical one.

At the same time, today’s financial anarchy has persuaded a growing number of experts that the world can no longer rely on such aging institutions as the International Monetary Fund to keep the global economy on an even keel.

At least some analysts believe that one necessary reform is a Federal Reserve that could more explicitly balance global financial realities against current conditions in the United States.

“Are there occasions when the Fed should set rates with an eye toward global stability or even global growth, if that means a slightly different level from that required to meet the short-term needs of the U.S. economy?” asked Jeffrey E. Garten, dean of the Yale School of Management and a former undersecretary of commerce, writing in Business Week. “The answer is yes.”

Fed officials insist that it is the global debacle’s impact on the United States--not the global financial crisis itself--that has caught their attention. That is consistent with the central bank’s historic mission.

Yet others see a watershed in this week’s rate cut--a rapid policy reversal sparked by events overseas.

“This is the first example in my memory where there’s really been an external development--an international shock--that is prompting the Fed to change its game plan,” Roach said.

In the elite world of central banks, there has been no stampede to join with the Fed in coordinating a broader cut in interest rates that could inject much more adrenaline into the global economy. Only the Bank of Canada followed suit immediately, with some expecting the Bank of England to join shortly.

Signals from continental Europe, meanwhile, have been mixed. Hans Tietmeyer, president of Germany’s central bank, recently made clear he had no interest in joining a rate cut coordinated to stimulate the global economy.

Japan has moved short-term rates so low--a microscopic 0.25%--that it has little room to cut further before people would be paid to borrow.

The Fed rate cut “shows that we have policymakers that know what they’re doing, compared to those in Japan, who are completely hapless, and those in Europe, who are a little bit asleep at the switch right now,” said Bruce Steinberg, chief economist at the Merrill Lynch investment firm.

Are they smart enough? Many wonder whether any national institution is capable of making the right decisions at a time when financial turmoil is leaping national boundaries with the furious and unpredictable force of a wildfire.

“Normally the patient is the domestic economy, and it’s a lot easier for the Fed to figure out if the patient is healthy--and what is required for it--than to figure out what is needed for the world economy,” said Jones, the economist at Aubrey G. Lanston. “This is Chairman Greenspan’s toughest challenge.”

* DEFENDING THE YUAN: China clamped down hard on currency trading. D1

* SLIDING SOUTH: The Dow Jones industrial average sank 237.90 points, while bond yields hit a record low. D3

* GROWTH REVISITED: The IMF cut growth forecasts for the world economy. D3