Sorry, Wall Street

Ben Bernanke and the Fed offer a nod to financial dangers from the credit squeeze, but leave interest rates at 5.25%

by Peter Coy

Federal Reserve Chairman Ben Bernanke refused to give a jittery Wall Street what it was looking for on Aug. 7—a promise of easier money. But the market, after an initial sell-off, decided the news wasn't so bad after all. Traders' confusion over the market's recent turmoil was evident as stocks quickly fell and then just as quickly jumped. Up as much as 1.4% on the day, the Standard & Poor's 500-stock index closed the day with a gain of about 0.6% at 1,476.71.

Bernanke and the other members of the Federal Open Market Committee (FOMC), which sets short-term interest rates, voted to keep the Fed funds rate at 5.25%, as expected. The committee voters held stubbornly to the view that higher inflation is a greater risk than slower growth. The Fed stated, "Although the downside risks to growth have increased somewhat, the committee's predominant policy concern remains the risk that inflation will fail to moderate as expected."

Reading between the lines, some optimistic Fed-watchers said the central bankers were acknowledging the risk of contagion from the subprime lending market to the rest of the credit markets and the economy—without saying they were riding to the rescue.

Danger: Credit Crunch?

Wrote T.J. Marta, RBC Capital Markets fixed-income strategist, "This statement merely acknowledges the obvious risks stemming from short-term perturbations while focusing on the more stable medium-term, macroeconomic outlook."

Bernanke is stuck in an increasingly difficult position. Credit has gone from lushly abundant in July to just adequate in August, and many economists worry that an outright credit crunch is taking shape. Subprime mortgage borrowers are having a hard time getting loans, and standards have tightened even for prime borrowers. Some corporations, too, report rising borrowing costs.

The ordinary remedy for a credit crunch—if one emerges—is to pump more money into the financial system. But Bernanke worries that doing so would ignite inflation and possibly cause another bubble in housing or the financial markets. Some economists argue that the housing bubble that recently popped was created by overly loose money under Bernanke's predecessor, Alan Greenspan.

Productivity Below Expectations

In many ways, the Fed is back in the jam of 2000, when the tech-spending bubble was bursting and the stock market was falling from its record highs, says Merrill Lynch economist David Rosenberg. Wrote Rosenberg before the Fed's action, "There are vivid signs of contagion just as there were back then. The economy today is arguably cooling off at a faster pace than it was in the latter part of 2000, and the unemployment rate has moved off the bottom just as it did back then."

Complicating matters for the Fed, hours before it announced its rate decision, the government announced an increase in non-farm business productivity that was below expectations: 1.8% at an annual rate in the second quarter vs. expectations of 2% or more. Combined with rising pay, that meant the labor cost of producing one unit of output rose at an annual rate of 2.1%. That "took the year-on-year rate up to a seven-year high of 4.5%," Rosenberg notes.

Growing productivity keeps a damper on inflation because people who are more productive can be paid more without straining employers' ability to pay. The housing downturn is probably responsible for the poor productivity showing, since builders are putting up far fewer homes but have cut employment only slightly, at least in the official statistics, says economist Kevin Cummins of UBS (UBS).

Some Good News

On the other hand, the news for Bernanke hasn't been all been bad. Gasoline prices have fallen nationally by about 30 cents from their early-summer peak in spite of continued high prices for crude oil. And stripping away volatile prices for food and energy, inflation has been moderating. The Fed's favorite gauge, the core personal consumption expenditures price index, rose a modest 1.9% in June, down from 2% in May. Although the economy is expected to slow in the second half, it managed to grow at a 3.4% annual pace in the second quarter.

Faced with conflicting evidence—sudden panic in the financial markets vs. reasonably healthy performance in the real economy—Bernanke & Co. chose to stand pat and leave monetary policy just the way it was.

Coy is BusinessWeek's Economics Editor.