The Fed's Plan: More Talk

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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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Inflation is a case in point. In recent years, when the Fed insists that it will keep inflation low, the public believes it, and therefore, as if by magic, inflation really does remain low: Trusting workers don't ask for higher pay and companies don't jack up prices. Even though oil prices have more than doubled over the past year and gasoline is $4 a gallon, the consumer price index rose a relatively modest 3.9% from April, 2007, through April, 2008. And recent history shows that when inflation is under control, growth tends to be steadier, too—the best of both worlds.

But the magic could run out frighteningly soon. If inflation stays above the Fed's target (1% to 2% a year, excluding food and energy), the central bank will be forced to defend its credibility by raising interest rates—even if that's not the right medicine for the economy. "They could quickly undo all they've done to keep the financial ship afloat," writes economist Edward Yardeni, president of Yardeni Research. One worry is that Bernanke is trying to out-tough Jean-Claude Trichet, president of the European Central Bank, who recently hinted at a July rate hike.

The opposite economic risk is that another couple of months of rising unemployment would worsen the foreclosure mess and threaten the financial system with even bigger losses. If so, the Fed might feel compelled to cut the federal funds rate again. Extremely low short-term rates would undoubtedly raise fears of inflation, which could become a self-fulfilling prophecy. That's what Bernanke was referring to in his Cape Cod speech when he said "an unanchoring of [inflation] expectations would be destabilizing for growth as well as for inflation."

How Tough Should Ben Be?

One thing Bernanke doesn't know is how businesses are going to react to the combination of higher oil prices and rising unemployment. Will they try to push up their own prices, or will they accept that customers don't have the money to pay more in a weak economy? As Bernanke noted on June 9, "Unfortunately, only very limited information is available on expectations of price-setters themselves"—that is, business executives.

The credit crunch also poses a conundrum for the Fed. Does Bernanke want to be seen as a market disciplinarian who will prevent wild excesses on Wall Street? Or does he want to reduce stress in the financial system so the flow of money from savers to borrowers gets back to normal? It's hard to have it both ways.

Inevitably, the Fed lost some credibility as an enforcer when it opened its lending window wide to commercial and investment banks and when it helped finance JPMorgan Chase's (JPM) emergency takeover of Bear Stearns in March. William Poole, who until recently was president of the Federal Reserve Bank of St. Louis, argues that the Fed needs to "define the scope of its emergency support for failing firms." Now that the Fed is lending money directly to investment banks, he says, political pressure could mount to lend money to other hard-pressed companies. "Would the Federal Reserve bail out a major airline?" asks Poole, now a senior fellow at the libertarian Cato Institute.

Bernanke has tried to make clear in speeches that the Fed is no patsy for Wall Street or any other sector. But he'd rather not have to prove his toughness and discourage future risky behavior by letting a big bank go belly up. That could be ­hazardous to the financial system, not to mention a blow to the bank's employees, lenders, and shareholders. Likewise, Bernanke would dearly like to wean broker-dealers from borrowing directly from the Fed, which they've been allowed to do since March. But given the continued stresses in the financial system, he may be forced to keep that lending avenue open.

Bernanke's Wish

In the medium term, the goal is to strengthen the financial system so the Fed doesn't need to resort to heroic measures when another big firm gets in trouble. That's the idea behind a plan announced on June 9 by Timothy Geithner, president of the Federal Reserve Bank of New York. Geithner said the Fed intends to get banks to build bigger shock absorbers into their balance sheets. He's also organizing a central clearinghouse for credit-default swaps that will reduce the systemic risk of cascading defaults in case some big player fails to make payments on those complex derivatives.

The Fed's concept: A stronger financial system will be able to survive even if some big bank goes down. Realizing that they can't count on a bailout, the banks' shareholders and creditors will monitor its safety and soundness more closely. Market discipline will function the way it's supposed to, and the Fed can recede into the background.

What does all this mean for how the Federal Reserve will operate in the coming months? Expect lots of speeches on monetary policy but little movement. The Fed's dramatic actions since the credit crunch hit last summer have demonstrated Bernanke's boldness. But deep down he remains a reluctant revolutionary—as Business­Week dubbed him in March—who understands the Fed's limitations and would like nothing better than to lower its profile. The question is whether the U.S. economy and financial system will cooperate enough to grant him his wish.

Coy is BusinessWeek's Economics editor.