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By John W. Schoen Senior Producer

Q: Who makes the interest decisions at the Federal Reserve? And are they politically motivated?  Is Greenspan a Republican? Recently, I noticed that interest rates are, of course, quite low, yet we have an expensive war going on that must be paid for.  Yet the "Fed" doesn't seem to take an expanding deficit into account when it makes its interest rate decisions. And don't very low interest rates destroy the "relative value" of our currency with respect to other currencies that can "pay" investors more?— Thomas V., Elmsford, N.Y.  

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A: The Federal Reserve's Open Market Committee meets about every six weeks to set interest rate policy. They do this by adjusting the fed funds rate and by adding or draining money from the banking system by buying or selling Treasury debt on the open market.

As for Greenspan's political leanings, he's worked under both Democratic and Republican administrations, and he's very careful in his statements on Capitol Hill to avoid partisan politics. But given the importance of the Fed's work and its impact on the election, it's almost impossible for the central bank to remain completely above politics. In the past, it has avoided major rate moves as elections approach. The Fed's main focus is to steer between fighting inflation (by raising rates) and keeping the economy moving along (by lowering them.) In its latest statement on the subject, the FOMC said it's currently not leaning one way or the other and will take a "measured" approach to rate moves. That sure sounds like they're trying to stay out of the political fray.

As for budget deficits, Chairman Greenspan has been clear that Congress needs to get the budget back into balance. As recently as this week, he repeated his warnings that the problem will only get worse as Baby Boomers begin retiring, placing even bigger strains on the budget.

Even it the Fed were to get political, it's grip on long-term interest rates is limited. Those are set by the bond market. Four times a year, the Treasury auctions off the new debt needed because Congress is spending more than it's collecting in taxes. Investors bid for that debt by naming the interest rate they'll accept; the government fills the lowest bids. Bonds then change hands in the secondary market (the bond market) and interest rates on that debt rise and fall based on market conditions. The size of the deficit only indirectly impacts interest rates; if investors think those deficits have weakened the U.S. economy, for example, they'll demand higher rates at the next auction or when they buy bonds in the open market. But as long as demand remain strong for Treasury debt, big deficits by themselves don't have much impact on rates.

All things being equal (which they never are) lower rates tend to lower the value of the dollar because Treasury debt is denominated in dollars. Higher rates boost the dollar in that they make those Treasuries more attractive to investors buying them with foreign currencies. But higher rates also tend to slow the U.S. economy, which can have the effect of weakening the dollar. (The Treasury officially supports a "strong dollar" but it has little practical control over its value.)

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