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Bernanke Walks Tightrope On Rates

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Bloomberg News

Published: September 18, 2007

Updated: 09/17/2007 10:22 pm

Federal Reserve Chairman Ben Bernanke is grappling with what predecessor Alan Greenspan might call a conundrum.

At issue is whether today's U.S. economy most resembles 1998, when Greenspan may have been too eager to cut interest rates, or 2000-01, when he may have been too slow. The trouble is, the situation now resembles a bit of both.

That increases the danger as the Fed's Open Market Committee meets today to decide on interest-rate policy. If Bernanke and his colleagues aim to avoid the mistake of 1998 and opt for caution, they risk a recession. If they push ahead with big rate cuts and growth proves resilient, they could find themselves with rising inflation fueled by record oil prices and a slumping dollar.

'This is a critical time for the Fed,' says Peter Hooper, who worked at the central bank during the financial crisis in 1998 and is chief U.S. economist for Deutsche Bank Securities in New York. 'The stakes have risen.'

The Fed today faces a financial-market-driven increase in borrowing costs, as in 1998, and a weakening economy comparable to 2000. The central bank responded to the former with three rapid-fire rate cuts, which some officials now think helped inflate the stock-market bubble. In 2000, it made the opposite mistake after the bubble burst, waiting too long to cut rates and allowing the United States to fall into recession.

Policymakers Appear Divided

Which model the Fed adopts will help determine whether it reduces the federal funds rate today by one-quarter or one-half percentage point. If 1998 is the guide, policymakers may settle for the smaller cut. Taking a cue from the 2000 episode would suggest a half-point drop in the rate, which is charged on overnight loans between banks.

Judging by their public comments, policymakers are divided over which path to follow. Futures trading indicates investors expect at least a one-quarter-point cut.

For J. Alfred Broaddus Jr., who helped fashion policy in 1998 and 2000 as Richmond Fed president, today's situation 'is more comparable to 2000 and 2001. There is a clear risk to the economy.'

Gross domestic product grew at an average annual rate of 2.3 percent in 2007's first half, and economists surveyed by Bloomberg expect that pace to continue through the end of the year. In 1998, the economy expanded 4.2 percent.

Broaddus says the Fed underestimated the economic effect of the stock market slide that began in March 2000 and eventually dragged the Standard & Poor's 500 index down more than 25 percent. 'We were a little slow to get under way' with rate reductions, he said.

This time, Fed officials have been surprised by the severity of the housing decline and the damage it has done to the rest of the economy. Minutes of the Fed committee's meeting Aug. 7 show policymakers judged that the housing slump 'could well prove to be both deeper and more prolonged' than expected.

Having left rates unchanged at that meeting, the Fed changed course 10 days later, lowering the discount rate - what it charges on direct loans to banks - and acknowledging that risks to the economy had risen 'appreciably.' The surprise move led investors to increase bets on a cut in the more-important fed funds rate at tomorrow's meeting.

Greenspan endorses his successor's handling of the market turmoil so far, saying in an interview with CBS television that he is 'not certain I would have done anything different.'

Even so, the Fed 'has been very slow to acknowledge what is one of the biggest busts in U.S. housing history,' said Allen Sinai, president of New York-based Decision Economics Inc.

Consumer Confidence Is Critical

What eventually helped push the Fed to cut rates at the start of 2001 was a sharp drop in consumer confidence, said Tom Simpson, a former senior official at the bank. As measured by an index compiled by the University of Michigan, confidence fell to a 2-year low in December 2000.

Confidence also is depressed this year, reaching its lowest level in a year in August and remaining close to that point in early September.

Fed officials say they are aware of the danger a sudden drop in confidence could pose if it leads to a pullback in household and business spending.

'I believe it poses an important downside risk,' Fed Governor Frederic Mishkin said in a speech Sept. 10 in New York.

Simpson, who retired from the Fed in 2006 after 30 years and now is at the University of North Carolina at Wilmington, sees another parallel with 2000: Monetary policy is restricting the economy after credit tightening by the central bank.

The Fed raised its target for the federal funds rate to 6.5 percent in May 2000 from 4.75 percent in June 1999. The rate now stands at 5.25 percent, up from 1 percent in mid-2004.

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