Bernanke's Bailout

The Federal Reserve chairman sent stocks surging and made many investors happy. But he's also taking risks with inflation

Federal Reserve Chairman Ben Bernanke grabbed the spotlight back from his book-writing predecessor, Alan Greenspan, on Sept. 18. Most experts were betting that the low-key academic would move cautiously and cut the federal funds rate by a minimal quarter percentage point. But Bernanke and his rate-setting colleagues cut the funds rate by a half percentage point, from 5.25% to 4.75%.

Suddenly it became clear who really matters—and it's not Greenspan, in spite of the media blitz surrounding the Sept. 17 publication of his book, The Age of Turbulence (BusinessWeek.com, 9/17/07). Bernanke, a former Princeton University economics professor, may not seek the spotlight, but he does have enormous influence over the direction of the U.S. and global economies as chief of the world's most important central bank.

Of course, monetary policy isn't supposed to be about machismo. And Bernanke undoubtedly went for the bigger-than-expected cut because he thought it was the right move for the economy, not because he wanted to one-up Greenspan. Still, the move indicates that Bernanke can't be pegged as a cautious, one-step-at-a-time technocrat. He has gotten bolder about using the power at his disposal.
Upside and Downside

Was it the right move? Hard to say. The financial markets certainly loved it. Stocks surged (BusinessWeek.com, 9/18/07) because the rate cut increases the chance that the economy will be able to avoid a recession and consumers will keep spending. Big gainers ranged from homebuilders such as Hovnanian Enterprises (HOV) and Beazer Homes USA (BZH) to retailers like Aéropostale (ARO) and 99 Cents Only Store (NDN). The National Association of Manufacturers called it "a decisive step." It's also good news for homeowners with adjustable-rate mortgages, whose reset rates might not be so high thanks to the Fed's cut.

But the big cut has downsides, too. It raises the risk of inflation. And it does little to correct the biggest problem of the moment: the paralysis in certain debt markets owing to fear about the quality of loan collateral such as residential mortgage-backed securities. Dispelling that fear requires improved disclosure about the real value of those securities—not necessarily lower short-term interest rates. In the worst case, cutting rates could be as ineffective as pushing on a limp string.

Sitting in the hot seat, Bernanke clearly decided that he couldn't afford to wait and see whether the markets would heal themselves. The half-percent cut is a blunt instrument, not a scalpel, but it's all he has at his disposal. Bernanke managed to get a unanimous vote from members of the rate-setting Federal Open Market Committee—a show of strength, considering that several voters had given speeches in the days before the meeting expressing skepticism about the need for a big cut.
From the Horse's Mouth

Here's the key paragraph of the Fed's statement, in its entirety:

"Economic growth was moderate during the first half of the year, but the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally. Today's action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time."

Translation: The problems started in housing. They spread through the credit markets. Now we have to do something to prevent them from spreading to the overall economy.
Getting Out in Front of the Problem

Evidence of how bad things are getting came shortly before the rate-setters met. A widely followed measure of homebuilder sentiment, the NAHB/Wells Fargo Housing Market Index, fell two points, to 20, tying the record-low reading of January, 1991, which was during a deep recession. Also making the Fed's decision easier was a moderate reading Sept. 18 on producer prices, which rose less than expected. If inflation is under control, the Fed has more leeway to cut rates.

What's next? John Silvia, chief economist of Wachovia Economics, speculates that the Fed might pause after this cut, having gotten all its cutting out of the way at once. "They probably have a weaker economic forecast than I do, and I think they saw enough credit concerns that they really wanted to get ahead of this a little bit," Silvia says. Whether the Fed can afford to stop now will depend on how effective this cut is, which won't be immediately apparent.

The funds rate is the rate on overnight loans of reserves between big banks. The Fed also cut the discount rate, which is for direct loans by the Fed, by half a percentage point. That, too, could help grease the wheels of the economy.

Coy is BusinessWeek's Economics Editor.