Spectre Of 'Bernanke Put' Looms

Source : The Business Times, September 20, 2007

Fed's half-point cut in federal funds rate also expected to produce new problems

Mr Bernanke: If the US economy continues to plunge and/or if the inflation rate goes up, he would have to defend Tuesday's decision in his memoirs

CRITICS of Alan Greenspan have depicted what was seen as an attempt by former chairman of the US Federal Reserve Board, Alan Greenspan, to ensure liquidity in the capital markets by lowering interest rates as the 'Greenspan put'. According to this argument, during the Greenspan term in the Fed, investors operated under the expectations that disorder in the capital markets would make it more likely than not that the US central bank would lower interest rates.

Hence, this 'Greenspan put' may have created incentives for some investors out to engage in risky and irresponsible behaviour since they expected that lower interest rates would serve to bail them out. Their risky behaviour, in turn, would end up igniting more disruptions in the financial markets.

So against the backdrop of the crisis in the US housing market and the ensuing credit crunch, it was not surprising that financial analysts were wondering whether the current Fed chief, Ben Bernanke, would decide to pursue a different course than that of his predecessor, and send a signal to investors that the central bank would refrain from responding to every disruption in the capital markets by cutting interest rates and so change expectations among investors.

As they were waiting for Tuesday's decision by the central bank's Federal Open Market Committee, that scenario - a Bernanke playing the role of the anti-Greenspan - had probably caused sleepless nights to many investors. But Mr Bernanke - ironically just a day after Mr Greenspan's published memoirs, The Age of Turbulence: Adventures in a New World had hit bookstores - did not disappoint the anxious investors.

In a very Greenspan-like move, Mr Bernanke and the rest of the Fed's policy makers slashed the benchmark federal funds rate by a half-percentage point as part of an effort to contain the turbulence in the financial markets, taking the overnight rate down to 4.75 per cent, its lowest level since May of last year.

In fact, Mr Bernanke and his colleagues had only three policy options available to them. They could have done nothing, which would have produced hysteria not only on Wall Street but also in Washington where leading Republicans and Democrats - both political parties have close financial ties to the investment community - have been pressing the Fed to 'do something' to relieve the credit crunch.

Or the Fed's policymakers could have cut the key rate by a quarter of a percentage point. Indeed, analysts had speculated that that would be exactly what the Fed would do - while not closing the door for future interest rate relief. Such a decision could have struck the right balance between the current worries over the problems in the housing market and the capital markets on the one hand, and possible concerns over future inflationary pressures on the other.

Nevertheless, with growing indications that the 'real economy' was in bad shape, including the downturn in the housing market as well as well rising unemployment and lower consumer confidence, the expectations on Wall Street was that the Fed would have no choice but to cut the key rate by half a point.

If the Fed had refrained from taking that expected step, it could have created havoc in the financial markets and sent shivers through Washington, especially in the White House. After all, President George W Bush recalls that his father had blamed Mr Greenspan's decision not to cut interest rates for the economic recession that helped bring about his loss of the presidential re-election bid in 1992.

But Tuesday's decision is expected to produce new problems for Mr Bernanke. If the economy is indeed now in such a mess that it required a major cut in rates, why wasn't the Fed chief able to detect earlier the dangers showing on the horizon? There is also the threat of inflation that could spread across the economy, a point that Mr Greenspan made during a television interview to mark the publication of his autobiography. Reports in the press suggested that some members of the Fed's policy makers had opposed a steep cut in rates which could ignite inflation. And once again, the Fed would be seen as bailing out the greedy and reckless investors, creating the spectre of a 'Bernanke put'.

In a statement issued after its meeting, the Fed said that 'the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally' and that the rate cut was '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'.

But the statement also included a warning about inflation, indicating that even though readings on core inflation 'have improved modestly' this year, 'some inflation risks remain', and stressing that the central bank would continue to 'monitor inflation developments carefully'. This warning might suggest that the Fed is not inclined to lower rates again.

While the Fed's decision helped ease concern among investors, it is not clear whether this aggressive move would revive the housing market and prevent the slowdown in growth which could lead to an economic recession. Hence, if the economy continues to plunge and/or if the inflation rate goes up, Mr Bernanke would have to defend Tuesday's decision in his memoirs.