BEN BERNANKE FOUND that narrow path between the rock and the hard place. He had to add liquidity to a credit market that is experiencing a crunch, and recognize that the economy is slowing, on the one hand, and not send a signal to improvident lenders and borrowers that all is forgiven–inviting them to sin again, with painless redemption assured.
So he lowered the discount and fed funds rates by 50 basis points–one-half percentage point. Here is what those moves are supposed to do. First, the lower discount rate will make it cheaper for banks to borrow against the collateral that they can’t borrow against in the seized-up credit market. That will help the troubled housing and mortgage sectors of the economy.
Second, the lower fed funds rate might–just might–bring other interest rates down, and give the economy a bit of a bump. It will almost certainly cause a further decline in the dollar, helping exports to pick up even more of the economic slack created by the decline in the home construction industry.
It is not certain, of course, that the economy needed such a lift. True, there are signs that it is slowing. But just because a slowing doesn’t feel quite as good as a speed-up, doesn’t mean we are heading into recession. Retailers from Wal-Mart to Saks Fifth Avenue are doing well, consumers have not retired from the malls, profits in many sectors are in good order, and unemployment is low by almost any standard.
My guess is that Bernanke would have preferred not to cut the fed funds rate by a full 50 basis points, if at all, because he believes the economy is doing reasonably well, and feels he must keep a wary eye on the inflation genie that is still pressing against the cap on the bottle in which it is entombed. That’s why the Fed money market gurus, in their accompanying statement, bowed to the chairman’s concern and pointed out that the danger of “inflation risks remain.”
But there were several pressures on Bernanke to cut the fed funds rate by a full half-point. First, he was the prisoner of a market that had built in an expectation of a fed funds cut; to have refused to bow to the pressure might have touched off a collapse of share prices.
Second, the chairman always wants a unanimous vote from his committee, and to get it he might have had to move a bit more drastically than he would have preferred. That might prove to be a mistake.
Third, the Fed faced a forecast of more turmoil in the mortgage and credit markets which, it says, “has the potential to intensify the housing correction and to restrain economic growth more generally.” This move gives it a bit of insurance that if some second, third or fourth shoes drop, it will not be accused of being behind the curve–as it has been of late.
Remember: Bernanke could not emulate his predecessor, who slashed the fed funds rate time and time again. When Alan Greenspan was in the Federal Reserve Board chair, there was no threat of inflation: he could cut with impunity. Bernanke, on the other hand, faces the inflationary pressures of rising oil and other commodity prices, rising real wages, a possible slow down in productivity growth, and a falling dollar. So he can’t play Greenspan, or give Wall Street traders all they want. But neither could he stand pat.
Instead, he and the monetary policy committee bowed in the direction of those who worry that the problems of the credit market will ripple into “the real economy” by cutting rates. But they indicated that they will continue to worry about inflation–perhaps warning the market not to expect a series of rate cuts. The Fed will watch developments, but has left itself freer than it was yesterday to do what it thinks best.
Irwin M. Stelzer is a contributing editor to THE WEEKLY STANDARD, director of economic policy studies at the Hudson Institute, and a columnist for the Sunday Times (London).
