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Saturday, 23 February 2008

Bernanke’s Fed

by Jeremy Siegel, Ph.D.

This isn't your grandfather's Fed. Nor is it Alan Greenspan's. This is Ben Bernanke's Fed - a far more dynamic and assertive creature.

Last Wednesday, Bernanke lowered short-term rates by 50 basis points, adding to the record 75 basis point drop he engineered on January 22nd. These two moves, barely a week apart, brought the Federal Fund's rate down a whopping 225 basis points -- 43% below where it stood less than five months ago. This is more aggressive than any decline that Alan Greenspan orchestrated during his almost two-decade tenure as Fed chief.

Bernanke is acting decisively and preemptively to try to stave off a recession, even though most economic indicators, including the Fed's official forecast, do not predict one. In fact, on the day of the emergency rate cut, no economic news, except for the sharp decline in world stock markets, occurred.

Is Bernanke right in moving so precipitously? Or is he caving into to political pressures to stimulate the economy in an election year and to popular desire to keep stocks out of a bear market?

At this point I'm going to give Bernanke's policy the "thumbs up." But I have my eyes on the foreign exchange and commodity markets. If the dollar tanks or commodity prices surge, then all bets are off, and Bernanke will have to put an end to these cuts and may have to actually increase rates. But if commodity prices don't rise and a recession is avoided, this new aggressive policy may well change the way central banks steer the economy.

Past Policy Moves Too Slow

It's long been debated how fast central banks should move to forestall a recession or inflation. I frequently criticized the Fed for moving too slowly, both on the upside and downside. Certainly, Greenspan's "baby step" increases of 25 basis points per meeting from 2004 through 2006 were far too cautious, and contributed to inflating the housing market.

But Greenspan was also too slow in cutting rates. From a peak of 6.5% in May of 2000, Greenspan had only lowered rates by one percentage point by the time the recession started in March 2001. In percentage terms, Bernanke's reduction already exceeds the reduction that Greenspan engineered in the first five months of 2001, when the economy entered a recession.

There are sound economic reasons for wanting short-term interest rates to move quickly. I've always considered short-term rates to be "shock absorbers" that should be changed frequently to offset shifts in economic growth. Faster adjustments in short rates could actually stabilize the long-term rate because long-term interest rates are influenced by both expectations of future central bank action and the state of the economy. If the central bank cuts rates too slowly, this generates market expectations of future rate cuts and pushes the long term rate down further. Moreover, this generates expectations of lower economic growth, which puts additional downward pressure on interest rates.

On the other hand, if rates rise too slowly, this puts strong upward pressure on long-term rates. As the economy started expanding in 1994, Greenspan began raising rates slowly. Long-term interest rates were clearly signaling that short rates were not moving up fast enough. This forced the Fed to raise rates in an emergency April meeting to dampen inflationary expectations and help stabilize long term rates.

In short, one could well argue that central banks should get to where they're going as quickly as possible. Although this policy will increase volatility of short rates, long-term rates are apt to be more stable. It's the long-term rates that have a very strong influence on housing and other capital spending, both important components of economic growth.

Inflationary Risks

Despite the benefits of lowering rates quickly, this policy also has dangers. Bernanke must keep his watch on the dollar, commodity prices, and inflationary expectations. Although central banks can smooth economic fluctuations, they cannot eliminate them altogether. Any attempt to stimulate demand when productivity and supply-side factors constrain output, can have disastrous consequences.

Throughout the 1970s the Fed overstimulated the economy, attempting to offset the drag from rising oil prices and other factors that reduced productivity. Instead of increased output, this policy lead directly to double-digit inflation, a situation that required a protracted period of tight money and two recessions to finally stamp out.

And there are other risks to moving too quickly. Part of the power of the central bank derives from investor perceptions of its ability to influence markets and the economy. If Bernanke's aggressive moves don't prevent a recession or a market decline, many will question the central bank's power. For this reason, I believe it is important to save powerful ammunition, such as a 75 basis point cut, for extreme conditions, such a the 9-11 terrorist attacks or when the stock market experienced a very serious decline, such as in October of 1987.

Markets are ruled by powerful forces, and if these forces have not yet been spent, it may be difficult for central banks to counteract them. If the central bank promises too much or uses its most powerful tools too soon, it risks losing investor confidence.

Bottom Line

Nevertheless, Bernanke's new bold and aggressive policy stands a good chance of working. But just as the Fed chief has been aggressive on the way down, he must also be vigilant and ready to change direction quickly if inflationary forces flare up. Almost all economists are in agreement that the central banks' commitment to price stability is its most important charge, and the goal of stimulating economic growth must take back seat when inflation threatens.

Much rides on Bernanke's success or failure. It is often said that the Fed chief is the second most powerful position in the government. With the upcoming election and a lame-duck president, it can be argued that Bernanke has taken over the mantle of the world's most powerful policymaker.

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