Can Ben Bernanke control the economy?

This NY Times Op-ed piece by James Grant argues that the Fed's ability to control the value of the dollar, and by extension the fate of the economy, is a myth. He applies an interesting analogy:



[Bernanke] insists that the Fed can keep the economy chugging and prices stable just by pushing a single interest rate (the so-called federal funds rate) up and down. Alan Greenspan, of course, has long espoused the same impossibility, as have other Federal Reserve officials and many private economists. A little thought experiment will reveal their error.



Let us say that Mr. Bernanke's field of expertise was energy prices rather than interest rates, and that the president named him to the Department of Energy rather than the Federal Reserve. If Mr. Bernanke then ventured a long-term oil-price forecast, would anyone even bother to write it down? Would anyone expect him, once confirmed, to actually fix the price?



Those who did would have to call the idea by its discredited name - price controls - and would have to explain why the secretary-designate knew better than the market at which price the supply of oil would meet the demand for oil. They would also have to explain why this episode in price controls would turn out better than the long series of flops that preceded it. The world would laugh.



Yet we seem to accept, and even desire, exactly such ludicrous claims of foresight from a Fed chairman. It follows that anyone who is willing to take the job as Fed chief is, by that reason, unqualified to hold it.

Fair enough. But to make the analogy complete, you have to assume that Mr. Bernanke had a monopoly on the supply of oil, and in fact was capable of pumping an unlimited amoung of oil from his wells at no cost. If this were true, then of course Bernanke could control the price of oil, regardless of fluctuations in demand; and with the price of oil inexorably set in stone, all other prices in the economy would be forced to adjust; and to the extent that the adjustment in prices was not instantaneous, the effect would be felt on quantities produced instead. This is pretty much how the Fed controls the economy by setting the federal funds rate.



Yes, the willingness of foreigners to hold dollars is a key determinant of its value and of U.S. interest rates. Demand for U.S. money, however, is but one half of the supply-demand scissors -- the Fed's control of the other half, supply, gives it a tremendous amount of power to influence the value of the dollar and the health of the U.S. economy.