By Peter Coy
February 27, 2008
SourceThe Fed chief's study of the 1920s, when central bankers mistakenly kept money tight, may mean he'll dismiss inflation and keep slashing rates
Federal Reserve Chairman Ben S. Bernanke went to Capitol Hill on Feb. 27 as if he were a general called from the battlefield to report on the progress of a losing war. The problem, as he explained to the House Financial Services Committee in his semi-annual monetary policy report, is the economy is fighting enemies on two fronts: a financial crisis and an economic slowdown on one side; inflation on the other. The more the Federal Reserve does to fight the financial crisis and potential recession, the worse inflation threatens to be. And vice versa.
It's an unenviable dilemma for Bernanke, who took office two years ago, succeeding Alan Greenspan. The Fed is operating, said Bernanke, "in an environment of downside risks to growth, stressed financial conditions, and inflation pressures."
Bernanke indicated that for now, at least, quelling the financial crisis and lifting the economy remains a higher priority for the Fed than chilling inflation. He said, "Financial markets continue to be under considerable stress." And although the Fed is still forecasting modest economic growth of 1.3% to 2% in 2008, "The risks to this outlook remain to the downside." Those risks include the possibility of worse-than-expected deterioration in the housing and job markets and the possibility that credit conditions, already tight despite the Fed's actions, "may tighten substantially further." As for inflation, he said Fed voters expect it to "moderate significantly in 2008."
With customary blandness, Bernanke said Fed rate-setters "will act in a timely manner as needed to support growth and provide adequate insurance against downside risks." To traders, this indicated Bernanke is sticking with his intention to push for a substantial cut in the federal funds rate at the next meeting of the Federal Open Market Committee on Mar. 18. Futures traders are betting on a half-point cut in the funds rate to 2.5%, from 3%, although after Bernanke's testimony, more traders speculated the cut might be as big as three-quarters of a percentage point.
Bad News on Many FrontsWhatever the Fed ends up doing won't be completely satisfactory, given the clash of objectives between protecting growth and fighting inflation. Gold, often a sensitive indicator of inflation fears, has soared to nearly $1,000 an ounce. Oil is trading for around $100 a barrel again. And on Feb. 26, the government announced producer prices soared in January. The annualized increase over the past three months was nearly 11%.
Offsetting those concerns, though, are more signs of a sharp slowdown in the economy. The Conference Board said on Feb. 26 that its February index of consumer confidence plunged 12 points, to 75, while the component measuring consumers' expectations hit a 17-year low. The same day, Standard & Poor's announced a 9.1% drop in its 20-city index of home prices from a year earlier, and RealtyTrac reported a 57% increase in foreclosure proceedings in January vs. a year earlier. On Feb. 27 the government reported an unexpectedly large drop in orders for durable goods.
Will Bernanke keep the emphasis on fighting the financial crisis and economic slowdown even if inflation continues to be a problem? One clue comes from his academic work on the Great Depression, which oddly enough posed a similar dilemma for the newly formed Fed. Bernanke has written that the Federal Reserve itself worsened what would have been an ordinary recession beginning in August, 1929. The Fed, he said in a 2002 speech, ignored severe troubles in the banking system and kept rates high to keep gold from escaping abroad.
Is History Repeating Itself?The parallels between the Great Depression and now are instructive, if inexact. In the 1920s there was a stock market surge, a tech craze (in radio), and a real estate bubble (in Florida). The Fed should have cut rates aggressively after the recession began in 1929, but instead it kept them high and even raised them in the mistaken belief that it was essential to keep the dollar's link to gold (high rates encouraged foreigners to hold dollars instead of exchanging them for gold). In his research at Princeton University, Bernanke showed that the longer countries remained on the gold standard during the 1930s, the deeper their depressions were. Back then, the hawks argued for staying on the gold standard.
The equivalent argument today is inflation should be Public Enemy No.
1. And the equivalent policy mistake would be keeping rates too high to fight price hikes. Bernanke may well lean away from making that mistake because his intuitions have been shaped so strongly by his long study of similar errors in the 1930s. "Bernanke is highly aware of the central bank's role as a lender of last resort to prevent serious disruptions to the financial system," says Barry Eichengreen, a University of California, Berkeley, economist.
That's not to say the Fed chief's choice is easy. He's also acutely aware that if higher inflation becomes entrenched, the Fed will eventually be forced to raise rates even more to beat it back down. Under the Fed chairmanship of Paul Volcker, it required lifting the federal funds rate to 19% and a pair of punishing recessions from 1980 to 1982 to break the inflation fever of the 1970s. And complex financial innovations such as securitization make it harder for the Fed to get a read on financial conditions, let alone influence them. So anything's possible. Says Eichengreen, "Central bankers are kind of making things up as they go."
Leadership May Lie in Cutting RatesThe Fed under Bernanke has been innovative in keeping the banking system well supplied with money. It has lent money to banks for longer terms and accepted more kinds of collateral from a broader range of institutions. It cut the federal funds rate by 1.25 percentage points in January alone. As bad as financial conditions are, they would probably be worse without some of the Fed's creative measures.
But the lower the funds rate gets, the more resistance Bernanke will face. Richard W. Fisher, president of the Federal Reserve of Dallas, was the lone dissenter to the bank's Jan. 30 cut. In a Feb. 7 speech in Mexico City he likened easy money to "truly great tequila"—tasty but dangerous. The question is how much Bernanke will defer to dissenters who oppose rate cuts. He once said the Depression occurred in part because "the central bank of the world's economically most important nation in 1929 was essentially leaderless and lacking in expertise." If that's his attitude, he may decide that leadership lies in cutting rates as long as needed to steer the economy clear of danger.
Coy is BusinessWeek's Economics editor.