The Fed Won't Give The Markets A Break

Amid inflation pressures, Bernanke isn't ready for a preemptive rate cut

by James Cooper

There may come a day when Federal Reserve Chairman Ben Bernanke faces his first test from a full-blown financial crisis--but not just yet. So far, what is happening is more like a pop quiz than a major exam. Nevertheless, all eyes are starting to focus on just how Bernanke & Co. factor the current turmoil into the Fed's policy decisions, especially because of the growing possibility that conditions could worsen and threaten the health of the economy.

The scrutiny began with the Fed's statement following its meeting on Aug. 7, when it left its target interest rate unchanged, at 5.25%. Prior to that session, investors were eager to see what weight the Fed would give the new developments. Would it alter its balance of worries by demoting inflation as its primary concern while elevating angst about economic growth? Would it go so far as to hint at a coming rate cut? In a nutshell, the answers were no and no.

Policymakers certainly felt obligated to acknowledge recent market volatility and tighter credit conditions while saying the downside risks to growth had increased "somewhat." But that was about it. Their basic message was unchanged: They expect the economy to grow at a "moderate pace," and they continue to see the threat of inflation as their "predominant policy concern." The Fed's response didn't go over well among some investors, who were looking for some relief. Even some economists think the Fed might be a little too detached from the current problems in the credit markets.

THE FED'S STATEMENT does suggest how the policymakers view the events of the past few weeks. In recent years, central bankers--not only in the U.S.--have warned about the seeming lack of risk built into the prices of many financial assets. The Fed most likely sees what's happening as a long-overdue normalization of investor assessments of risk. Put another way, this normalization helps clear up the "conundrum," as Alan Greenspan put it, of why bond yields remained so low and stock prices continued to soar, despite significant policy tightening by the Fed and other central banks.

If that's all it is, the Fed will probably stay on the sidelines and let the correction in the stock and bond markets run its course, although not without some short-run pain on Wall Street, a more prolonged housing recession, and another nick out of economic growth in the second half. Eventually, a more normal level of volatility will return to the financial markets, and investors will come away properly chastened. In the long run, credit will be costlier, but assets will be more accurately priced, and Fed policy moves will regain some of their effectiveness.

MOST LIKELY, HOWEVER, it won't be that simple. In coming months, the Fed is going to be pulled in opposite directions. It must be attentive to nagging uncertainties in the inflation outlook, even as worries persist that the market mess will hammer the economy.

The newest inflation concern is a clear slowdown in productivity growth, which is adding upward pressure on corporate costs at a time when labor markets are tight, energy and commodities prices are up, and the falling dollar is pushing up import prices.

At the same time, policymakers have to be concerned that markets will not just normalize, but overdo it, as they often do. That is, investor fear could drive up risk premiums on all assets--not just the riskiest ones--to the point where even creditworthy borrowers cannot secure funds or financially sound companies cannot acquire equity financing.

That's the point where risk normalization becomes a full-blown credit crunch that threatens the functioning of the entire financial system and the stability of the economy. Obviously, the Fed doesn't believe that's what's happening right now. But despite its Aug. 7 comments, recent developments in the markets and the heightened chances of a nasty outcome have significantly altered the risks in the outlook for both the economy and Fed policy over the coming months.

Whatever economic growth in the second half of the year was probable a few weeks ago, the pace most likely will be a notch slower now. Many economists are already shaving their forecasts.