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These are times of shattered illusions. The attacks of Sept. 11 destroyed our sense of invulnerability, and now the mythology of the new economy is receding before the reality of declining jobs and profits. To this list may soon be added the Federal Reserve's presumed power, which during the reign of Chairman Alan Greenspan has grown to immense proportions in the popular imagination. People began thinking that by well-timed changes in interest rates, the Fed could steer the economy along a path of low inflation, high employment and rapid growth.

It is doubtful whether Greenspan ever bought into this line. He has seen too many business cycles to harbor a false sense of control. But the success of his stewardship has inspired unrealistic expectations about the power of monetary policy - changes in interest rates and money supply orchestrated by the Fed and other government central banks. The Fed has cut interest rates nine times this year. The Fed funds rate has dropped from 6.5 percent in January to 2.5 percent, the lowest level since 1962. Yet the economy was still deteriorating even before Sept. 11.

Japan is Exhibit A in the limits of monetary policy. In 1999, the Bank of Japan lowered its official interest rate to zero. All the while, Japan's economy sputtered. It is now in recession. Low interest rates are supposed to spur more lending and borrowing. But in Japan, total bank lending has declined for 45 consecutive months.

Government over-regulation and bad banking practices have left devastating legacies. So much of the economy has been protected from competition by regulation, subsidies and cartels that it's hard for new companies and industries to get started. This shrinks the pool of potential borrowers. Meanwhile, Japan's banks still suffer from all the poor loans they made in the the 1980s. They aren't eager to lend.

The point is that even zero interest rates can't reinvigorate the economy if other conditions are unhealthy. What we call "the economy" is simply the baffling amalgam of businesses, financial markets, government regulations, cultural attitudes and foreign trade. Monetary policy is only one part and influence. This is true in Japan and in the United States. Just because the Fed is lowering interest rates does not mean that businesses and consumers will borrow more. Although the U.S. economy is more flexible than Japan's, the Fed is still hostage to the after-effects of the longest boom in American history. Banks' commercial and industrial loans have dropped $27 billion in 2001. Consumer borrowing rose 9.3 percent in 2000, but since June, it has stagnated. One reason is that monthly debt payments were near a record level.

Moreover, the Fed's power over interest rates is loose. The Fed buys and sells U.S. Treasury securities on the open market. When it buys, it adds to the money supply. The funds it uses to pay for securities increase the reserves that banks use to make loans. As a result, interest rates tend to drop. But through this process, the Fed directly sets only one market interest rate: the Fed funds rate. It's the rate on overnight loans, mainly among banks.

All other rates respond - haphazardly and inconsistently. In September 2000, conventional mortgage rates were roughly 8 percent; now they're a bit below 7 percent. Because mortgages and corporate bonds are long-term loans, their interest rates reflect investors' views of future inflation and risk. By contrast, some bank lending rates follow the Fed closely. This year banks' "prime rate" has dropped from 9.5 to 5.5 percent.

In the wake of the terrorism, we've been told to be patient. This will take time. The same advice applies to the economy: recovery may take time. Although the Fed's actions also influence the economy through other channels (the stock market, housing prices, the dollar's exchange rate), these connections are even more inexact and unpredictable than the borrowing-lending channel. Over the past decade, all the gritty and inconvenient details have been lost in the adulation for Greenspan. The Fed is presumed to be able to avert almost any economic danger. This is, alas, an illusion.

Washington Post Writers Group

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