Wall Street Rules
by Dean Baker; June 23, 2006

The idea that the government, or some arm of government, is controlled
by a special interest group naturally prompts outrage. The government
should be answerable to the public as a whole, not special interests
that have extraordinary political power.

For this reason, it was striking to see a piece ("Confusion From the
Fed Head") in the Washington Post's Outlook section in which Richard
Yamarone, an investment analyst, matter of factly asserted that Wall
Street controls the Federal Reserve Board of Fed. As Mr. Yamarone put
it, "The Fed chairman may be appointed by the president and confirmed
by the Senate, but his real bosses are on Wall Street."

This statement is an incredible indictment of the U.S. political
system. The Fed has far more direct impact on the U.S. economy than any
other agency of the government. It can control how many people in the
United States have jobs. While the media tend to speak of the Fed's
actions in euphemisms, when the Fed raises or lowers interest rates
(its main policy tools) it is deciding whether the economy should
create more or fewer jobs.

Cuts in interest rates are intended to boost the economy. Lower
interest rates make it easier for families to buy cars and homes and
for businesses to invest. If more cars and homes are sold and more
factories or offices are built, then more people are employed. In the
opposite case, if the Fed raises interest rates, it makes it harder to
buy cars and homes and for businesses to invest. This means that fewer
people will be employed.

As a practical matter, it is often easier for the Fed to destroy jobs
than create them. Sometimes lower interest rates will not be sufficient
to boost the economy. (A worker concerned about losing her job may be
reluctant to buy a new car regardless of how low the interest rate
falls.) By contrast, if the Fed raises interest rates high enough, it
can be sure that it will eventually slow the economy and reduce
employment.

The Fed generally decides to throw people out of work when it gets
concerned about inflation, as is the case at present. The logic is
simple; if unemployment increases, then workers will find it more
difficult to push up wages. Bosses will decide that they can just hire
another worker from among the unemployed if their current workers ask
for pay increases. Since wages are a cost to businesses, if wages rise
less rapidly, then costs will rise less rapidly, and firms will
probably slow the pace at which they raise their prices. In other
words, by using unemployment to slow wage growth, the Fed can restrain
inflation.

It is important to understand that this method of restraining inflation
does not affect everyone equally. The people who lose their job when
the Fed raises interest rates tend to be factory workers, retail
clerks, and custodians, not doctors, lawyers, and CEOs. In other words,
the Fed controls inflation by forcing the middle class and poor to face
higher unemployment and take pay cuts.

There is also an important racial component to the Fed's inflation
fighting. As a rule of thumb, the unemployment rate for African
Americans tends to be twice the overall unemployment rate, while the
unemployment rate for African American teens is typically six times the
overall average. This means that if the Fed pushes up the overall
unemployment rate from 4.5 percent to 6.5 percent, it will raise the
unemployment rate for African Americans from roughly 9.0 percent to
13.0 percent. It will raise the unemployment for African American teens
from roughly 27 percent to 39 percent.

It is important to understand these facts when we hear it asserted
(correctly) that the Fed answers to Wall Street. The most disadvantaged
people in society are the ones who suffer when the Federal Reserve
Board decides to clamp down on inflation. While many economists pretend
that the decision to raise interest rates to slow inflation is an exact
science, like physics, the fact is that they have almost no idea how
inflation moves through the economy. The vast majority of the economics
profession got inflation completely wrong in the nineties.

What does this mean? Wall Street doesn't like inflation. It hurts
profits, end of story. Therefore, Wall Street demands that the Fed
raise interest rates to throw poor people and African Americans out of
work. That isn't the assessment of a crazed radical. You heard it from
an investment analyst in the Washington Post.