Greenspan's Miscues Haunt Bernanke as Fed Weighs Cut (Update1)

By Rich Miller

Sept. 17 (Bloomberg) -- Federal Reserve Chairman Ben S. 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 2000-2001, 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 tomorrow 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 now 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 U.S. to fall into recession.

Template for Action

Which model the Fed latches onto will help determine whether it reduces the federal funds rate tomorrow by a quarter or a half percentage point. If 1998 is the guide, policy makers 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, policy makers are divided over which path to follow. Futures trading indicates investors expect at least a quarter-point cut.

For J. Alfred Broaddus Jr., who helped fashion policy in both 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.

`A Little Slow'

Broaddus says the Fed underestimated the economic impact of the stock market slide that began in March of 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 says.

This time, Fed officials have been surprised by the severity of the housing decline and the damage it has wreaked on the rest of the economy. Minutes of the FOMC's Aug. 7 meeting show policy makers judged that the housing slump ``could well prove to be both deeper and more prolonged than had seemed likely earlier this year.''

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's Endorsement

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,'' says Allen Sinai, president of New York-based Decision Economics Inc.

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

Confidence is also 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 well aware of the dangers that a sudden drop in confidence could pose if it led to a pullback in household and business spending.

`Important' Risk

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

Simpson, who retired from the Fed in 2006 after 30 years and is now 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 of 2000 from 4.75 percent in June of 1999. The rate now stands at 5.25 percent, up from 1 percent in mid-2004.

Deutsche Bank's Hooper sees a danger of recession if the Fed is too cautious in cutting rates.

In remembering the lessons of 2000 too well, though, the central bank would risk losing ground in its fight to keep inflation contained.

``Rate cuts are not free,'' says Marvin Goodfriend, senior vice president at the Richmond Fed from 1993 to 2005 and now a professor at Carnegie Mellon University in Pittsburgh. ``You pay a price.''

Consider TIPS

The inflation risk makes it a good time for investors to consider Treasury Inflation Protected Securities, says James Evans, who manages $4 billion of inflation-linked bonds at Brown Brothers Harriman & Co. in New York. ``The TIPS market is poised to do pretty well,'' he says.

Laurence Meyer, a Fed governor from 1996 to 2002, cautions against giving too much weight to comparisons with 2000. He remembers hearing plenty of anecdotes back then about a slowing economy. Today, the weakness appears more narrowly focused on housing.

A regional Fed survey released Sept. 5 found the economic effects of the August credit market rout ``limited'' outside of housing.

``Our economy appears to be weathering the storm thus far,'' Dallas Fed President Richard Fisher said in a Sept. 10 speech in Laredo, Texas. ``As yet, tighter credit conditions do not appear to have had a major impact on overall economic activity outside of real estate.''

Greenspan acknowledges that the Fed risked fanning inflation when it lowered interest rates in 1998. Yet he argues in his just-released book, ``The Age of Turbulence,'' that the chance was worth taking to keep the crisis from dragging down the economy.

Others who were policy makers at the time are not so sure. Meyer, now vice chairman at Macroeconomic Advisors LLC in Washington, says the lesson of that year is that ``it's very hard to judge the linkages between the financial markets and the economy,'' he says. ``You can over-react.''

To contact the reporter on this story: Rich Miller in Washington rmiller28@bloomberg.net

Last Updated: September 16, 2007 19:32 EDT

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