The Fed's Plan: More Talk

With little room for the Fed to make a course adjustment safely, Bernanke's balancing-act comments carry even greater weight than usual

by Peter Coy

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Bernanke: He sounds hawkish on inflation but knows a rate hike could be painful David Burnett/Contact Press Images

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Illustration by Gluekit; with photos by Karen Bleier/AFP/Getty Images; Siede Preis/Photodisc/Getty Images

Imagine you're Federal Reserve Chairman Ben Bernanke. Giant mousetraps litter the landscape: $135-a-barrel oil, a rising jobless rate, a vicious credit crisis. People are begging you for help. Yikes! What do you do?

You go to a Boston Fed conference on Cape Cod and give a speech on "Outstanding Issues in the Analysis of Inflation." You express mild optimism about the economic outlook, and you promise that the Fed will "strongly resist" an upward creep in inflation expectations.

That, anyway, is what Bernanke actually did on June 9. And although it was just talk, markets responded powerfully. Traders concluded that the Federal Reserve won't let inflation erode the value of the dollar. That day and the next, the dollar staged its biggest two-day rally against six major currencies since January, 2005, even though the government reported on June 10 that record imports pushed up the U.S. trade deficit in April. Some analysts even predicted a long-term rally in the value of the dollar—a vote of confidence in the strength of the U.S. economy.

Not Much Maneuvering Room

But Bernanke believes it's far too early to declare victory over the economic slump and the credit crunch. He remains alert to the risks from what Fed officials have dubbed the "adverse feedback loop," in which a deteriorating economy causes more people to default on mortgages, which runs up bank losses and exacerbates the credit crunch. While news reports focused on the optimistic tone of Bernanke's speech, the cautious side came across as well when he said "the ongoing contraction in the housing market and continuing increases in energy prices suggest that growth risks remain to the downside." In Senate testimony on June 5, Fed Vice-Chairman Donald Kohn shared Bernanke's caution about the spillover from housing.

That's why traders who have been sifting Bernanke's words for evidence that the Fed will raise interest rates soon are most likely wrong. Sure, the futures market is placing a probability of nearly 50% on a hike in the federal funds rate to 2.25% or more at the Aug. 5 meeting of the Federal Open Market Committee—up from a 7% chance a week ago, according to a Bloomberg Financial Markets analysis. And stocks fell June 11, as rate-hike talk spread. But bettors have a history of jumping the gun on rate hikes. The futures market can be "a terrible predictor of policy," wrote Jan Hatzius, Goldman Sachs' (GS) chief U.S. economist, on June 11.

Bernanke's words need to have an impact because he has little freedom to act. After a series of dramatic moves dating back to last summer—including slashing the federal funds rate to 2% and devising brand-new ways to assist commercial and investment banks—he can't undertake any more heroic measures without causing painful side effects. If Bernanke tries any harder to keep the economy growing by cutting interest rates, he runs the risk of causing higher inflation. Conversely, if he tries any harder to cool off inflation through higher interest rates, he could push the fragile economy over the edge.

He's in a similar bind in coping with the credit crunch. If he does any more to prop up troubled financial institutions, he'll invite them to take foolish chances again in the next boom. But if he tries any harder to show his tough-guy credentials by refusing to bail out a failing bank, he could trigger a systemic meltdown.

Cashing In on Credibility

Bernanke's goal, it appears, is to achieve an elusive balance between conflicting objectives, doing just enough on each of his many battlefronts to show he means business but not doing so much that he loses ground on the other fronts.

If Bernanke is lucky, he will be able to get through the next few months by drawing on the credibility that the Fed has achieved and stored up over the years. The beauty of credibility is that if you have enough of it, you can achieve your objective just by jawboning. The danger, of course, is that credibility can be lost in an instant.