Imagine you're Federal Reserve Chairman Ben Bernanke. Giant mousetraps litter the landscape: $135-a-barrel oil, a rising jobless rate, a vicious credit crisis. People are begging you for help. Yikes! What do you do?
You go to a Boston Fed conference on Cape Cod and give a speech on "Outstanding Issues in the Analysis of Inflation." You express mild optimism about the economic outlook, and you promise that the Fed will "strongly resist" an upward creep in inflation expectations.
That, anyway, is what Bernanke actually did on June 9. And although it was just talk, markets responded powerfully. Traders concluded that the Federal Reserve won't let inflation erode the value of the dollar. That day and the next, the dollar staged its biggest two-day rally against six major currencies since January, 2005, even though the government reported on June 10 that record imports pushed up the U.S. trade deficit in April. Some analysts even predicted a long-term rally in the value of the dollar—a vote of confidence in the strength of the U.S. economy.
Not Much Maneuvering Room
But Bernanke believes it's far too early to declare victory over the economic slump and the credit crunch. He remains alert to the risks from what Fed officials have dubbed the "adverse feedback loop," in which a deteriorating economy causes more people to default on mortgages, which runs up bank losses and exacerbates the credit crunch. While news reports focused on the optimistic tone of Bernanke's speech, the cautious side came across as well when he said "the ongoing contraction in the housing market and continuing increases in energy prices suggest that growth risks remain to the downside." In Senate testimony on June 5, Fed Vice-Chairman Donald Kohn shared Bernanke's caution about the spillover from housing.
That's why traders who have been sifting Bernanke's words for evidence that the Fed will raise interest rates soon are most likely wrong. Sure, the futures market is placing a probability of nearly 50% on a hike in the federal funds rate to 2.25% or more at the Aug. 5 meeting of the Federal Open Market Committee—up from a 7% chance a week ago, according to a Bloomberg Financial Markets analysis. And stocks fell June 11, as rate-hike talk spread. But bettors have a history of jumping the gun on rate hikes. The futures market can be "a terrible predictor of policy," wrote Jan Hatzius, Goldman Sachs' (GS) chief U.S. economist, on June 11.
Bernanke's words need to have an impact because he has little freedom to act. After a series of dramatic moves dating back to last summer—including slashing the federal funds rate to 2% and devising brand-new ways to assist commercial and investment banks—he can't undertake any more heroic measures without causing painful side effects. If Bernanke tries any harder to keep the economy growing by cutting interest rates, he runs the risk of causing higher inflation. Conversely, if he tries any harder to cool off inflation through higher interest rates, he could push the fragile economy over the edge.
He's in a similar bind in coping with the credit crunch. If he does any more to prop up troubled financial institutions, he'll invite them to take foolish chances again in the next boom. But if he tries any harder to show his tough-guy credentials by refusing to bail out a failing bank, he could trigger a systemic meltdown.
Cashing In on Credibility
Bernanke's goal, it appears, is to achieve an elusive balance between conflicting objectives, doing just enough on each of his many battlefronts to show he means business but not doing so much that he loses ground on the other fronts.
If Bernanke is lucky, he will be able to get through the next few months by drawing on the credibility that the Fed has achieved and stored up over the years. The beauty of credibility is that if you have enough of it, you can achieve your objective just by jawboning. The danger, of course, is that credibility can be lost in an instant.
Inflation is a case in point. In recent years, when the Fed insists that it will keep inflation low, the public believes it, and therefore, as if by magic, inflation really does remain low: Trusting workers don't ask for higher pay and companies don't jack up prices. Even though oil prices have more than doubled over the past year and gasoline is $4 a gallon, the consumer price index rose a relatively modest 3.9% from April, 2007, through April, 2008. And recent history shows that when inflation is under control, growth tends to be steadier, too—the best of both worlds.
But the magic could run out frighteningly soon. If inflation stays above the Fed's target (1% to 2% a year, excluding food and energy), the central bank will be forced to defend its credibility by raising interest rates—even if that's not the right medicine for the economy. "They could quickly undo all they've done to keep the financial ship afloat," writes economist Edward Yardeni, president of Yardeni Research. One worry is that Bernanke is trying to out-tough Jean-Claude Trichet, president of the European Central Bank, who recently hinted at a July rate hike.
The opposite economic risk is that another couple of months of rising unemployment would worsen the foreclosure mess and threaten the financial system with even bigger losses. If so, the Fed might feel compelled to cut the federal funds rate again. Extremely low short-term rates would undoubtedly raise fears of inflation, which could become a self-fulfilling prophecy. That's what Bernanke was referring to in his Cape Cod speech when he said "an unanchoring of [inflation] expectations would be destabilizing for growth as well as for inflation."
How Tough Should Ben Be?
One thing Bernanke doesn't know is how businesses are going to react to the combination of higher oil prices and rising unemployment. Will they try to push up their own prices, or will they accept that customers don't have the money to pay more in a weak economy? As Bernanke noted on June 9, "Unfortunately, only very limited information is available on expectations of price-setters themselves"—that is, business executives.
The credit crunch also poses a conundrum for the Fed. Does Bernanke want to be seen as a market disciplinarian who will prevent wild excesses on Wall Street? Or does he want to reduce stress in the financial system so the flow of money from savers to borrowers gets back to normal? It's hard to have it both ways.
Inevitably, the Fed lost some credibility as an enforcer when it opened its lending window wide to commercial and investment banks and when it helped finance JPMorgan Chase's (JPM) emergency takeover of Bear Stearns in March. William Poole, who until recently was president of the Federal Reserve Bank of St. Louis, argues that the Fed needs to "define the scope of its emergency support for failing firms." Now that the Fed is lending money directly to investment banks, he says, political pressure could mount to lend money to other hard-pressed companies. "Would the Federal Reserve bail out a major airline?" asks Poole, now a senior fellow at the libertarian Cato Institute.
Bernanke has tried to make clear in speeches that the Fed is no patsy for Wall Street or any other sector. But he'd rather not have to prove his toughness and discourage future risky behavior by letting a big bank go belly up. That could be hazardous to the financial system, not to mention a blow to the bank's employees, lenders, and shareholders. Likewise, Bernanke would dearly like to wean broker-dealers from borrowing directly from the Fed, which they've been allowed to do since March. But given the continued stresses in the financial system, he may be forced to keep that lending avenue open.
In the medium term, the goal is to strengthen the financial system so the Fed doesn't need to resort to heroic measures when another big firm gets in trouble. That's the idea behind a plan announced on June 9 by Timothy Geithner, president of the Federal Reserve Bank of New York. Geithner said the Fed intends to get banks to build bigger shock absorbers into their balance sheets. He's also organizing a central clearinghouse for credit-default swaps that will reduce the systemic risk of cascading defaults in case some big player fails to make payments on those complex derivatives.
The Fed's concept: A stronger financial system will be able to survive even if some big bank goes down. Realizing that they can't count on a bailout, the banks' shareholders and creditors will monitor its safety and soundness more closely. Market discipline will function the way it's supposed to, and the Fed can recede into the background.
What does all this mean for how the Federal Reserve will operate in the coming months? Expect lots of speeches on monetary policy but little movement. The Fed's dramatic actions since the credit crunch hit last summer have demonstrated Bernanke's boldness. But deep down he remains a reluctant revolutionary—as BusinessWeek dubbed him in March—who understands the Fed's limitations and would like nothing better than to lower its profile. The question is whether the U.S. economy and financial system will cooperate enough to grant him his wish.