Stability's now No.1 priority for Fed

Inflation takes back seat to resolving credit crisis

August 21, 2007|By Bloomberg News

Federal Reserve policymakers, who declared that inflation was their paramount challenge just two weeks ago, have been forced to make financial-market stability the trigger for changes in interest rates.

By lowering the discount rate and issuing a statement conceding threats to the economy, Fed policymakers effectively ripped up the economic-outlook statement from their Aug. 7 meeting.

The lowering of the discount rate Friday came after months of assurances that the subprime-mortgage crisis was contained.

Some economists describe the about-face as Fed Chairman Ben S. Bernanke's first serious error since taking office last year.

"It was a rookie mistake," said Kenneth H. Thomas Jr., a lecturer in finance at the University of Pennsylvania's Wharton School in Philadelphia. The Fed "underestimated liquidity needs" of investors and the fallout from the housing recession, he said, adding, "This demonstrates the difference between book-smart and street-smart."

Bernanke, a former chairman of the economics department at Princeton University, has elevated the role of forecasts in Fed policy rather than amassing clues from dozens of market indicators as predecessor Alan Greenspan did.

The Fed forecasts showed that "moderate" growth would continue, and that inflation remained the biggest danger.

The credit collapse has undermined that stance, and the Fed's rate-setting Open Market Committee may cut the more important benchmark federal funds rate by at least a quarter-point to 5 percent at or before its next meeting Sept. 18, analysts say.

"Sometimes, the dynamics change very, very quickly," said Laurence H. Meyer, a former Fed governor who voted for the three reductions in 1998 after currencies in Asia, Russia and Latin America tumbled. Bernanke's shift "tells us how difficult it is to translate financial turbulence into the macroeconomic forecast."

On Friday, Fed policymakers lowered the discount rate - what it charges banks for direct loans - by 0.5 percentage point to 5.75 percent, to increase liquidity.

Meyer, vice chairman of Macroeconomic Advisors LLC in Washington, recommended before the Fed Open Market Committee meeting Aug. 7 that policymakers cease describing inflation as the biggest risk.

By saying the risks to growth and inflation were roughly equal, the central bank could have given itself room to maneuver if markets - already weakening - continued to slide.

The Fed said in its statement three days ago that "the downside risks to growth have increased appreciably" because of the tumult in markets. The Fed abandoned the prediction of a "moderate" expansion, and inflation wasn't mentioned.

While leaving the federal funds rate at 5.25 percent, the Fed said it is "prepared to act as needed to mitigate the adverse effects on the economy."

The rate - what banks charge each other for overnight loans - influences the prime rate, one of the most widely used benchmarks in setting home equity lines of credit and credit card rates.

Last week's policy shift notwithstanding, Bernanke's moves to resolve the credit crunch so far have been restrained. Even then, and unlike the Greenspan era, it was Fed policymakers doing the talking, not one individual.

"We're getting a nice further look at the new Bernanke Fed," said Ethan Harris, chief U.S. economist at Lehman Brothers Holdings Inc. in New York. "He definitely wants to use the committee and these more formal directives," as opposed to Greenspan's preference for speeches laden with "code words."

The reduction in the discount rate, which is used less than the federal funds rate as a policy-making tool, wasn't directed at the broad economy so much as at trying to ease gridlock in credit markets.

The decision to keep the federal funds rate unchanged may be a sign that the central bank is still wary of bailing out bad bets by institutions and investors.

Bernanke, 53, is an expert in inflation-targeting and has spent much of his career in academia. The Fed's seven-member Board of Governors includes other academics: Randall S. Kroszner, a former University of Chicago Business School professor, and Frederic S. Mishkin, a monetary policy researcher and professor from the Graduate School of Business at Columbia University in New York.

"It is a team that is new to the challenge, but it is a pretty smart group," said Harris. Bernanke "is familiar with the history of the Fed, the policy errors, and he is a Great Depression buff."

With Friday's action, the Fed is "trying to strike the right balance between doing nothing and riding to the rescue," said Gary Schlossberg, senior economist at Wells Fargo Capital Management.

Baltimore Sun Articles
|
|
|
Please note the green-lined linked article text has been applied commercially without any involvement from our newsroom editors, reporters or any other editorial staff.