Five Key Questions for Bernanke

With the next rate-setting meeting fast approaching, here are some issues that are surely top of mind for the Federal Reserve chairman

The chairman of the Federal Reserve is like a golfer trying to line up a tee shot while thousands of spectators shout advice. The higher the stakes, the louder the buzz from the gallery, and the stakes are superhigh after the government's surprising report on Sept. 7 that employment shrank in August. The decline in jobs, the first such drop in four years, hammered stocks (, 9/9/07), with the Dow Jones industrial average tumbling 250 points. Among the hardest-hit stocks were Caterpillar (CAT), IBM (IBM), ExxonMobil (XOM), Harley Davidson (HOG), and Krispy Kreme Doughnuts (KKD).

Fed Chairman Ben Bernanke can't possibly heed every piece of advice he's getting on how to keep the U.S. economy on the fairway, so to speak. But there are a few things he can't help but pay attention to. With the next meeting of the rate-setting Federal Open Market Committee coming up on Sept. 18, here are five issues that Bernanke surely has in mind as he ponders whether, how soon, and how much the Fed needs to cut interest rates.

1. How weak is the U.S. job market, really? Much worse than most experts thought only recently. On Sept. 7, the Labor Dept. announced that payrolls fell by 4,000 in August, which was far worse than economists' expectations of a 100,000 increase in jobs. Michael Englund of Action Economics observed ominously that "the reported headline jobs dropoff looks similar to the declines seen at the start of the last two recessions" (, 9/7/07). A big part of the drop came from a decline in government jobs, and construction employment continues to fall. But economists are more concerned about the overall drop in private payrolls. This report makes it highly likely that the Fed will cut the federal funds rate by at least a quarter-percentage-point on Sept. 18, with more cuts likely at future meetings.

2. Why are the credit markets still so troubled? By several measures, the financial system still isn't doing its job of circulating money to the people and businesses that need to grow. Companies that borrow money by issuing asset-backed commercial paper are finding few bidders. And the London Interbank Offered Rate, or LIBOR—the interest rate on short-term loans between banks—has been rising steadily, indicating a crisis of confidence. The problem is that the financial system depends on good information about the quality of collateral for loans, and lenders no longer trust the information they're getting, especially when the collateral might include reckless or fraudulent subprime loans. Bernanke needs to figure out how long it will take for the markets to sort out the problems in subprime and return to normal. The longer Wall Street takes to clean up its mess, the greater the danger to Main Street.

3. Since the housing downturn is the core of the problem, when will housing recover? The foreclosure rate is likely to keep rising all through 2007 and probably through the first half of 2008. That's from no less an authority than Douglas Duncan, chief economist of the Mortgage Bankers Assn., which announced on Sept. 6 that the percentage of homes entering the foreclosure process hit a record in the April-June quarter (, 9/7/07). Bernanke knows that the economy will continue to face strong headwinds as long as people are being thrown out of their homes for nonpayment of mortgages. That's another argument for cutting interest rates.

4. How much of a risk is inflation? Unfortunately, inflation is a real concern for the Fed. Wages are growing faster than worker productivity. That's inflationary because it means companies have to raise prices to maintain profit margins in the face of higher employment costs. So far inflation has remained tame, but the slowdown in productivity over the past couple of years gives the Fed less maneuvering room to cut rates than it had in past economic crises. A rate cut might stimulate consumer and business demand, but that could just exacerbate the inflation problem.

5. How much good would rate cuts do now? Remember, the Fed can only affect short-term interest rates by making lots of money available in the banking system. It has much less impact on long-term rates, such as fixed-rate mortgages and corporate bonds. The nightmare scenario for the Fed is that it cuts interest rates and only manages to get the markets worried about higher inflation without reviving the economy. That's a recipe for stagflation. Would a cut in the federal funds rate now help? Probably. Can the Fed single-handedly keep the U.S. economy out of a slump or a recession? No.

But rest assured, that fact won't stop the shouting from the spectator gallery. Much is riding on how Bernanke thinks through these questions as he lines up his next shot.

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