Bernanke's History Lesson

The Fed chief's study of the 1930s, when central bankers mistakenly kept money tight, may mean he'll dismiss inflation and keep slashing rates

Mark Wilson/Getty Images

by Peter Coy

Federal Reserve Chairman Ben S. Bernanke went to Capitol Hill on Feb. 27 as if he were a general called from the battlefield to report on the progress of a losing war. The problem, as he explained to the House Financial Services Committee in his semi-annual monetary policy report, is the economy is fighting enemies on two fronts: a financial crisis and an economic slowdown on one side; inflation on the other. The more the Federal Reserve does to fight the financial crisis and potential recession, the worse inflation threatens to be. And vice versa.

It's an unenviable dilemma for Bernanke, who took office two years ago, succeeding Alan Greenspan. The Fed is operating, said Bernanke, "in an environment of downside risks to growth, stressed financial conditions, and inflation pressures."

Bernanke indicated that for now, at least, quelling the financial crisis and lifting the economy remains a higher priority for the Fed than chilling inflation. He said, "Financial markets continue to be under considerable stress." And although the Fed is still forecasting modest economic growth of 1.3% to 2% in 2008, "The risks to this outlook remain to the downside." Those risks include the possibility of worse-than-expected deterioration in the housing and job markets and the possibility that credit conditions, already tight despite the Fed's actions, "may tighten substantially further." As for inflation, he said Fed voters expect it to "moderate significantly in 2008."

With customary blandness, Bernanke said Fed rate-setters "will act in a timely manner as needed to support growth and provide adequate insurance against downside risks." To traders, this indicated Bernanke is sticking with his intention to push for a substantial cut in the federal funds rate at the next meeting of the Federal Open Market Committee on Mar. 18. Futures traders are betting on a half-point cut in the funds rate to 2.5%, from 3%, although after Bernanke's testimony, more traders speculated the cut might be as big as three-quarters of a percentage point.

Bad News on Many Fronts

Whatever the Fed ends up doing won't be completely satisfactory, given the clash of objectives between protecting growth and fighting inflation. Gold, often a sensitive indicator of inflation fears, has soared to nearly $1,000 an ounce. Oil is trading for around $100 a barrel again. And on Feb. 26, the government announced producer prices soared in January. The annualized increase over the past three months was nearly 11%.

Offsetting those concerns, though, are more signs of a sharp slowdown in the economy. The Conference Board said on Feb. 26 that its February index of consumer confidence plunged 12 points, to 75, while the component measuring consumers' expectations hit a 17-year low. The same day, Standard & Poor's announced a 9.1% drop in its 20-city index of home prices from a year earlier, and RealtyTrac reported a 57% increase in foreclosure proceedings in January vs. a year earlier. On Feb. 27 the government reported an unexpectedly large drop in orders for durable goods.