Return to Virginia Business - February 2003

The Richmond Fed
Under Broaddus, the secretive district Federal Reserve bank has new clout. Yet, the sputtering economy is forcing a rethinking of how the Fed does business. What will it mean for the Richmond bank and its Mid-Atlantic region?

by Jack Milligan

Related Story:
- The Fed’s very own Cold War bunker

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The vantage point of the empire of J. Alfred “Al” Broaddus Jr. is certainly impressive. His office at the Federal Reserve Bank of Richmond is on the top floor of a dramatic, white building that looks like a smaller version of the now-destroyed World Trade Center designed by the very same Japanese architect. Far below, the James River roils briskly past boulders and bridges. In the far distance stretches Broaddus’ domain — the Fifth District of the Federal Reserve System that includes Virginia, West Virginia, North and South Carolina and Maryland.

Broaddus, chatting and sipping coffee, is a trim, bespectacled man in shirtsleeves with the persona of the popular college economics professor that he once was. His office is modern and marked by beige walls and furnishings. Behind his desk is a painting of a country building with a red, tin roof. It’s a fitting image because when the Richmond native isn’t conferring with Federal Reserve Chairman Alan Greenspan or top corporate executives, he’s out in small towns such as Wytheville, bucking up small business people and gathering economic intelligence first hand.

The Richmond Fed, of which he is president, is a quiet, little-understood and very powerful institution that plays key roles in overseeing the economy of the Mid-Atlantic. Like the 11 other regional Fed banks, it also provides the Fed in Washington with data and advice that help set the federal funds rate that, in turn, pegs most interest rates, throttling the U.S. economy up or down.
A Ph.D. graduate in economics who regularly writes for academic journals, Broaddus has given the Richmond Fed a strong intellectual foundation since he became president in 1993 after being research director for years. He recruited smart young economists from the best schools, encouraged their research and stood behind them when their opinions ticked off pooh-bahs at the Federal Reserve Board in Washington.

Under Broaddus and his strident anti-inflation stance, the Richmond Fed has won a reputation for original thinking. Combined with Broaddus’ long experience, his work at developing the brain trust at the Richmond Fed has given him major credibility in monetary policy circles. Bennett McCallum, an economics professor at Carnegie Mellon University in Pittsburgh, says that of all the Fed banks, Richmond has had the greatest impact on monetary policy and procedure over the past 20 years. “I think its research has had a huge impact on the [Federal Reserve] system,” he says. “And a lot of that is because of Al.”

Such clout is making Broaddus a key player at a critical time. The Federal Reserve System and Greenspan are undergoing some wrenching reassessments of what their roles should have been during the dot-com and telecommunications bubbles of the late 1990s and should be now that the economy and stock markets can’t seem to fire on all cylinders. One school says that the once god-like Greenspan is screwing things up.

That may sound like an improbable question given that the 15 percent inflation during the Jimmy Carter years of the late 1970s eroded the value of savings and made it nearly impossible for the wages of most Americans to keep pace with rising prices. Later, interest rates soared into the high teens as Paul Volcker — whom Carter had appointed as Fed chairman in 1979 — fought to bring runaway inflation to heel. Given today’s low inflation rate of approximately 1.5 percent and low interest rates, one could argue that monetary policy of recent years has worked quite well, thank you.

But the success of its long-running, anti-inflation campaign has not spared the Fed or chairman Greenspan from much second-guessing of late. Some critics believe the central bank, which sets monetary policy through its control of interest rates, should have raised rates in the late 1990s to cool down an overheated stock market. And they worry now that low rates have created a dangerous bubble in the nation’s housing market. Then there’s the sorry state of the U.S. economy, which seems to be stuck in low gear even though the Fed has cut short-term rates to 1.25 percent — their lowest point in 40 years — causing some people to fret about the risk of deflation and to wonder if the Federal Reserve is running low on ammunition.

All this public criticism is quite a comedown for a chairman, and for an institution, that were worshiped in the financial world over the past several years. And it points to an underlying question about the role of the Federal Reserve. Is it merely enough for the central bank to keep inflation under control, as many monetary policy conservatives argue, or should it be more aggressive in managing the economy — pricking, for example, bubbles before they get too large?

Broaddus has some pretty strong opinions on all of this — views that are being noted in the national business press. His position is crystal clear. In the mid-1990s, he developed a reputation as a staunch “inflation hawk” when he argued strongly that the Fed should raise rates to put a hammerlock on inflation once and for all.

The Fed sets monetary policy through the Federal Open Market Committee, a group of 20 sachems who meet eight times a year. It consists of a seven-member Board of Governors including chairman Greenspan, and the presidents of the 12 district banks in the Federal Reserve System. The governors and the president of the Federal Reserve Bank of New York are permanent voting members of the FOMC while the remaining presidents vote in an annual rotation that works out to every third year. As a voting member in 1994, and again in 1997, Broaddus voted to raise rates five times and also dissented five times when the FOMC chose not to raise rates. He also supported three straight rate increases in early 2000. No other FOMC member took a tougher stand against inflation during that period of time than Broaddus.

In Broaddus’ view, the U.S. economy has reached a point of “price stability” where the inflation rate is low enough to be relatively benign. But he’s not willing to proclaim that inflation is dead. “If it’s not properly managed it can always return,” Broaddus says. “I think it’s very important that the Federal Reserve not relax. We need to keep our guard up against a resurgence of inflation at some point down the road.”

Broaddus is a firm believer that the Fed’s primary mission is just that — keep inflation on a short leash, which allows the economy to grow to its fullest potential. “It’s all about growth ultimately,” he says. “It’s not just about keeping the currency stable. It’s about what that [stability] allows an economy to achieve in relation to its potential.” Just as important, perhaps, is the expectation by financial markets and business leaders that the Fed will maintain its vigilance against inflation. “What’s sometimes frustrating for us is that not everyone sees the linkage between inflation and inflation expectation on the one hand and interest rates on the other,” he says. “One of the reasons why rates are low now — especially long-term rates — is that expectations of inflation have diminished significantly. So when people lend money or invest, they are not adding an inflation premium on to the return they demand.”

In a speech in early January, two weeks after he spoke with Virginia Business, Broaddus said that he sensed “the emergence within the Fed of a more cohesive strategy of monetary policy than at any time in the last three decades.” And this strategy has two elements. One is a strong commitment to maintaining “high credibility” with financial markets and businesses that it will keep inflation under tight control. The other is the Fed’s willingness to aggressively cut rates to help ease the economy through rough spots. The two are linked, because when the Fed’s credibility is high, it has more leeway to cut rates without spooking the markets and corporate leaders with fear that it might allow the inflation beast to escape from its cage.

One could argue that the Fed’s credibility is quite strong at the moment because in the 16 months since the Sept. 11 terrorist attacks, it has cut short-term rates 5.25 percent without the monster reappearing. And when you have low inflation and the expectation that it will persist, Broaddus said in his speech, you have “the monetary policy equivalent of finding the Holy Grail.”
But that’s not how some monetary policy experts see it. They charge that the Fed should have raised rates in the late 1990s when equity valuations — particularly on the technology-intensive NASDAQ stock market — had skyrocketed to unprecedented heights. Greenspan himself had warned against the stock market’s “irrational exuberance” in 1996, but Fed policy makers chose not to do anything about it.

One critic who believes the Fed should have made a preemptive strike against the stock market bubble is Stephen Cechetti, a former research director at the New York Fed who now teaches economics at Ohio State University. Cechetti argues that the loss of capital-gains taxes after the market finally collapsed in 2000 is partly responsible for the soaring budget deficits in many states, Virginia included. “The Internet bubble created these problems, and they surely involve hundreds of billions of dollars,” he wrote recently. He reasons that even a modest 50 to 75 basis point tightening in interest rates in the spring of 1997 might have cooled off the red-hot economy. “With a slower growth forecast, the stock market bubble may have been less extreme,” he wrote.

Other critics believe the Fed is making the same mistake now with the housing market. Mortgage debt — including home equity loans — grew nearly 10 percent in 2000 and averaged over 11 percent through the first three quarters of 2002, according to the Financial Markets Center, a Philomont, Va.-based research organization that focuses on monetary policy issues. The center’s Executive Director Jane D’Arista says, “The bursting of a mortgage bubble could unleash broader financial disruptions with deeper macroeconomic implications than the shakeout following the S&L crisis of the 1980s.”

Part of the problem is the degree to which commercial banks have become exposed to the mortgage market through their aggressive lending activities. Another problem is that pension and mutual funds are big holders of mortgage-backed securities, which would drop in value if the housing market collapsed and large numbers of borrowers defaulted on their loans. D’Arista believes the Fed “need not stand by passively while yet another sector follows the [downward] trajectory of the Nasdaq.” One thing it could do is put pressure on banks to reign in their mortgage lending operations. “You can’t get a bubble without a rise in credit,” D’Arista says.

In various speeches of late, Greenspan himself has argued that it would have been unwise for the Fed to have tried to pop the stock market bubble in the late 1990s, in part because the prerequisite rate hikes might have thrown the economy into a deep recession — the very scenario it would be trying to avoid. Broaddus agrees, and charges that the anti-bubble proponents have a “very tenuous point of view.” He adds: “I’m not sure it would be in the public interest to [try to] do that. I’m not sure that it’s feasible to do that.”

Greenspan and Broaddus win support from another former research director at the New York Fed, Columbia University professor Fredric Mishkin, who has argued that equity valuations are largely driven by factors other than monetary policy. In a research paper that Mishkin and fellow economist Eugene N. White published in January 2002, they studied the impact that 14 stock market collapses in the 20th century had on the U.S. economy. They concluded that the 2000 collapse did not appear to put stress on the underlying economy, probably because the economy was otherwise quite strong. Their findings imply that it may have been safer for the Fed to have waited for the bubble to burst and then pump more liquidity into the financial markets by lowering rates — which is precisely what it did throughout 2001.

The 63-year-old Broaddus has spent his entire professional life working as a central banker, and has the background one expects. After graduating from Washington & Lee University, where he was elected Phi Beta Kappa, and studying in France under a Fulbright Fellowship, Broaddus spent two years in the Army. He later got a Ph.D. in economics from Indiana University and joined the Richmond Fed as an economist in 1970, becoming the bank’s director of research in 1985.

Marvin Goodfriend, who succeeded Broaddus as research director when he became president, was a young economist in those days. He recalls Broaddus urging him to do research that would have an impact on the Federal Reserve. Goodfriend, now a senior vice president and policy advisor to Broaddus, says that took some courage. “Al didn’t know where that would take us,” Goodfriend says. “He didn’t know what that would look like.”

In their then-parochial mindset, during the mid-1980s most Fed banks limited their research activities to economic matters within their own regions. Bennett McCallum of Carnegie Mellon University and a consultant to the Richmond Fed for the past 20 years, recalls that under Broaddus economists like Goodfriend started writing controversial articles about policy issues “that some people at the board of governors didn’t want to see in print.” McCallum says the board wanted Broaddus to be “less confrontational,” but he refused to muzzle his economists. Under Broaddus and later Goodfriend, the bank became a leading proponent of the idea that the Fed’s primary mission is to maintain a low inflation rate rather than try to micromanage the economy.

Like all district presidents, Broaddus does a great deal more than attend FOMC meetings at the Federal Reserve in Washington and argue about interest rates. The Richmond Fed distributes paper and coin money to depository institutions in the Fifth District when there is a greater demand for cash. It also supervises 368 bank holding companies and state chartered banks belonging to the Federal Reserve System that are headquartered in the Fifth District. Only the New York Fed has a larger number of banking assets under its supervision than Richmond, whose district includes large banks headquartered in North Carolina.

The Richmond Fed’s research unit also collects data from within the region, which becomes part of the Fed’s so-called Beige Book, a comprehensive overview of business activity throughout the U.S. that serves as a kind of economic electrocardiogram. Its research also becomes grist for the monetary policy mill when Broaddus and his colleagues do meet in Washington to vote on interest rates.

Like all professional economists, Broaddus spends lots of time poking through the economy’s viscera — but he also spends a surprising amount of time informing himself first-hand on conditions within the region. He travels extensively to many places throughout the district to speak with local business groups and hear from them in return. “Al is extremely approachable,” says Jeremiah J. Sheehan, the retired chairman of Reynolds Metals Co. and until recently chairman of the Richmond Fed. “He will take the same amount of time with a local businessman that he takes with Alan Greenspan.”

Broaddus also relies on the Richmond Fed’s research staff and his policy advisor, Marvin Goodfriend. He reads everything he can get his hands on, including newspapers and magazines from within the region. And he travels. “I’m going to be in Washington, Charlotte and Columbia, but we also try to go to smaller places so we can talk to the small business people,” he explains. “The art is taking all that information in and getting a story out of it, and seeing what the main themes are.”

And the “story” that Broaddus sees in the Fifth District is not a pretty one at the moment. Southwest Virginia and West Virginia, where the local economies are highly dependent on natural resources like coal and timber, remain depressed. And the textile and furniture industries in the Carolinas and Southside Virginia are being hurt by a flood of imports from Mexico under the North American Free Trade Agreement, and also from Asia. “Workers in those industries are going to have to adjust and that’s tough,” says Broaddus, who describes himself as a free trader. “People are out of work and they ask me, ‘What can we do to replace these activities?’” Broaddus believes the best thing the Federal Reserve can do is keep the economy stable while they rebuild their communities.

Of course, Northern Virginia — where much of the so-called New Economy of the late 1990s was centered — is hurting. Broaddus disputes whether there was ever such a thing as a New Economy, and instead thinks it was just the old economy that had become much more productive because of advancements in areas like information technology and computing. “I think it was just the great old economy responding to innovation,” he says.

Broaddus has become a voting member again this year, and he expects the national economy to grow in 2003, although he’s concerned about the “extraordinary uncertainty” he senses among business executives concerned about an impending war with Iraq. “People are reluctant to commit to major capital projects as long as that wariness exists,” he says. And if businesses don’t start spending at some point, it could imperil the economy’s tepid recovery. “When I end a meeting I’ll say, ‘I don’t want to take too much of your time. I want you to get out there and spend money and get the economy rolling again.’”

Questions about the Fed’s control of monetary policy extend beyond the bubble issue. With short-term rates at just 1.25 percent and with the economy seemingly resistant to the Fed’s monetary pump priming, some worry that the United States might tumble into the same deflationary spiral that has gripped Japan in recent years. Broaddus believes that this fear is overblown — a view also shared by Cechetti — and says the central bank has many policy tools to stimulate the economy.

Other monetary policy experts, Cechetti among them, argue conversely that the Fed must soon raise rates or risk setting the inflation beast loose again. Cechetti says that Fed policy changes often operate with a 12-to 24-month lag time, implying that a higher inflation rate somewhere down the road could be in the offing. Or as he puts it, “When will the inflation that they seem to be encouraging take off?”

Broaddus knows this damned-if-you-do-and-damned-if-you-don’t dynamic comes with the territory. Fed watching has become an increasingly popular sport — and everyone, it seems, has an opinion. Broaddus recalls being in Washington two years ago for an FOMC vote. Prior to the meeting there had been intense speculation in the press as to whether the committee would cuts rates by a quarter or half point. Broaddus says he got on the elevator at the Federal Reserve with a member of the building’s maintenance staff. “He got on with me, didn’t say anything, just nodded,” Broaddus says. “When we got to the floor where he was getting off, he turned around and said, ‘Do half a point.’”

Return to Virginia Business - February 2003