Bernanke's Dilemma

The markets are clamoring for rate cuts, but weak U.S. productivity gains and strong global growth may limit the Fed's options

By Michael Mandel

Housing is in the pits. The credit markets are in turmoil. With the loss of 4,000 jobs in August, the labor market has slowed to a crawl. And Wall Street is clamoring for Fed Chairman Ben S. Bernanke to cut interest rates aggressively to pump up the economy.

But investors, homeowners, and workers may be disappointed if they are hoping for more than one, or perhaps two, small cuts in the benchmark federal funds rate. In his defining moment as Fed chief, Bernanke is picking his way through an immensely complicated and uncharted economic landscape. Unless the bottom suddenly falls out of the job market or some other economic calamity unfolds, he's likely to show great restraint in the coming months.

The U.S. economy, once inward-looking and dominated by manufacturing, is now service-oriented and closely tied to the rest of the world. That means the Fed chairman's calculations will have to account for the health of the global economy—which so far has been strong. "We've been revising the growth forecast for the U.S. down, and up for the rest of the world," says Tim Condon, a top economist at ING (ING ) in Singapore.

Equally important, Bernanke is getting conflicting signals on the long-term growth rate of productivity, or output per hour, arguably the single most important statistic for setting monetary policy. Long-term U.S. productivity growth is expected to be 2.25% to 2.5% per year, according to a BusinessWeek survey of six leading economists. That's lower than the 2.75% average estimate in 2004, when BusinessWeek asked the same question, but it's still quite strong by historical standards. "The implications for the Fed are that potential output is running above actual output," says Dale W. Jorgenson, a Harvard University economist. In other words, there's enough slack in the economy that businesses can produce more without lifting inflation. As a result, the Fed can pump up growth by cutting rates.

But for Bernanke and the Fed, there are also disquieting signs that the productivity boom of the past 10 years could be coming to an end. The economists were projecting future productivity growth—but recent history has not been so rosy. Nonfarm business productivity, averaged over the past four quarters, is up only 0.5% compared with the previous year, the slowest pace since the mid-1990s. Such small gains in productivity, if they persist, will make it extremely hard for Bernanke to embark on a sustained program of rate cuts.

Indeed, the big danger for Bernanke is that the U.S. may face a reversal of the pattern of the past decade, when rising productivity was the main strength of the U.S. economy. Such increases powered rising real wages in the 1990s and rising profits in the 2000s. Strong productivity growth also drew foreign investors to the U.S. stock and bond markets, which kept interest rates low while reducing worries about the big trade deficit.

Rising productivity also greatly increased the range of options open to former Fed Chairman Alan Greenspan. He could keep interest rates low without worrying much about igniting inflation. Perhaps more important, rapid productivity growth gave Greenspan the freedom to cut rates aggressively in response to the financial crisis of 1998 and the dot-com bust.

By contrast, even the possibility of slowing productivity growth hems in Bernanke on two sides. Combined with the slow growth of the labor force, it puts the U.S. perilously close to stalling out. "It would not take much to tip the economy into recession," says Martin N. Baily of the Brookings Institution and former head of the Council of Economic Advisers under Bill Clinton. "The collapse of the boom in nonresidential construction, for example."

But the slow productivity trend, if it continues, could also weaken the case for sharp rate cuts. Why? Because Bernanke, like all central bankers, remembers the main lesson of the 1970s. Back then, the Fed tried to make a slow-productivity economy run faster by cutting rates, and ended up instead with "stagflation"—an unpleasant combination of weak growth and rising inflation. No one wants that to happen again. Indeed, the minutes from the last meeting of the Fed's Open Market Committee, in early August, make it clear that "slower trend growth in productivity" was high on the list of concerns.

The problem for Bernanke is that long-term productivity trends can shift sharply and without warning. In the 1970s, productivity growth took a nosedive that economists simply did not expect, leading to years of weak growth and high inflation. Then, in the 1990s, information technology suddenly took hold as an economic force, and the result was the New Economy boom. There's nothing to stop productivity from decelerating again.

Still, it's worth noting that Bernanke could cut rates sharply to deal with a financial crisis even if productivity is not rising. That's what Greenspan did in the aftermath of the October, 1987, market crash. At the time, productivity growth was nonexistent and core inflation was well above 4%, but Greenspan slashed the fed funds rate by a full percentage point to help bail out the market and the economy.

After the crisis was over, however, Greenspan quickly reversed course and took back the rate cuts. Within eight months after the 1987 crash, the fed funds rate was back to the same level as before. Bernanke might have to follow the same strategy if productivity growth stays low.

If the uncertainty about productivity weren't bad enough, the new links between the U.S. and the rest of the world create more imponderables for Bernanke and for monetary policy. Strong growth in Asia and elsewhere, for instance, makes other central banks a lot less likely to cut rates in lockstep with the Fed as they have in the past. "The impact from a U.S.-originated shock wave will be much less painful now than it was at the beginning of this decade," says Lim Kyung Mook, economist at Korea Development Institute in Seoul. He notes that growth in South Korea's gross domestic product will probably exceed 4.7% this year, higher than previously forecast. Korea's central bank raised interest rates in July and August.

Such overseas rate hikes, combined with Fed rate cuts, could make it less attractive to invest in the U.S. and cause the dollar to fall further. That would make imports more expensive and send inflation higher. Already the price of non-petroleum imports is rising at a 2.8% rate, compared with 1.9% in 2006.

Bernanke also has to consider whether the new links to the global economy will moderate or aggravate a U.S. slowdown. One possibility is that consumers and businesses might cut back on imports rather than on domestically produced goods. In the past, for example, a housing downturn might have led to big layoffs at U.S. factories making construction materials, furniture, and appliances. But with much more of that manufacturing capacity outside the U.S., fewer domestic jobs may be lost. Indeed, the slight decline in the trade deficit in July may be a precursor of things to come.

On the other hand, U.S. manufacturers might possibly close down yet more domestic plants to reduce costs, especially if productivity is lagging. "When the U.S. sneezes, there's an opportunity for the rest of the world," says B.V.R. Subbu, former head of Hyundai Motor India. He recently bought the Daewoo car plant near Delhi and is turning it into an auto components shop for exports. "Once U.S. investors realize they have to make money some other way, they will push manufacturers to perform better and better, and they will push more manufacturing to India."

Bernanke also must consider the impact of globalization on the service sector. On Sept. 12, the Census Bureau released results of the latest quarterly survey of services, which showed a big gain in revenues in the second quarter in such globally oriented industries as consulting and computer systems design. But the same day, Electronic Data Systems Corp. (EDS ) announced it will offer early retirement to 12,000 workers in the U.S. Meanwhile, the company has been expanding operations in low-cost countries.

Bernanke came to the Fed with the idea of making monetary policy more predictable and easier for financial markets to understand. But in an unpredictable, rapidly changing world, that goal may be far out of reach.

With bureau reports

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