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The Bernanke Agenda


By Peter Coy Cool, calm, and collected, Federal Reserve Chairman Ben S. Bernanke is driving Wall Street batty. When traders scream about a recessionary "credit crunch," the former professor acknowledges their concerns but predicts continued economic growth. When they plead for easier money, Bernanke and his fellow rate-setters firmly hold the line. "Scandalous," sputtered one North Carolina market strategist. Jim Cramer, the TV stockpicker, nearly melted in a pool of his own sweat on a recent program, saying Bernanke must flood the system with money to stop financial Armageddon. Shouted Cramer: "He has no idea how bad it is out there!"

The Street may be dismayed by Bernanke's sangfroid, but it shouldn't be surprised. This is exactly the kind of policy that Bernanke has spent his entire career arguing for. At Princeton University, where Bernanke taught from 1985 to 2002, he said central bankers should avoid getting caught up in the gyrations of the financial markets and focus instead on measures of the real economy, such as growth and inflation. He said the Fed should set a target rate for inflation and then steer monetary policy to hit that target--an approach that would change central bankers from financial demigods into something more like engineers.

TEST CASE FOR A PHILOSOPHY

Bernanke hasn't talked about inflation targeting much since he became Fed chairman in February, 2006, but the spirit of the approach was evident on Aug. 7 when the Federal Open Market Committee announced it was leaving the federal funds rate unchanged at 5.25%. Nodding just slightly to concerns about a credit crunch, the committee said "credit conditions have become tighter for some households and businesses, and the housing correction is ongoing." But it went on to say: "Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters." The committee even said it continues to regard inflation as a bigger risk than an economic slowdown.

The market's current craziness is a perfect test case for Bernanke's circumspect approach because there's no evidence so far of a major systemic crisis that would require him to abandon his theories and open the monetary floodgates. Yes, stock and junk bond prices have fallen, the subprime mortgage market is in dire straits, and a few Wall Street firms, including Bear Stearns, have taken a hit. But elsewhere, contagion is more of a future worry than a present-day reality. Over the past year, there has been an infinitesimal 0.1 percentage point increase in the yield on corporate bonds rated A by Standard & Poor's, according to a Merrill Lynch & Co. index. Even B-rated bonds, classified as junk, have seen their yields go up only 0.6 percentage points over the past year, to just under 9%, and rose 1.7 points since February, after a dip during the winter. That hurt, but it's pretty small compared with 1998, when markets really did seize up. Then, yields on B-rated bonds leaped 3.1 points in five months, to over 12%. Under then-Chairman Alan Greenspan, the Fed reacted by slashing interest rates--creating the conditions, some critics say, for the stock-market bubble of 1999 and 2000.

Bernanke's approach recognizes that the Fed can't be all things to all people. If the Fed lowered rates to rescue subprime borrowers and their lenders, it would raise the risk of excessive borrowing and speculation in other sectors, possibly causing higher inflation and a stock bubble.

Bernanke's approach is being supported by many of his fellow academic economists. Among the most prominent is Allan H. Meltzer, a Carnegie-Mellon University monetary economist who is writing a history of the Fed. "The people on Wall Street are making a lot of noise because they don't like to lose money, and we can all understand that," he says. "But...it would be a huge mistake to change policy to rescue a bunch of people who made stupid mistakes." In fact, argues Meltzer, losses by speculators could clean out the financial markets and make them healthier. "Capitalism without failure is like religion without sin," Meltzer says. "It doesn't work."

Wall Streeters, with their seven- and eight-figure pay, are hardly sympathetic figures. Unfortunately for millions of subprime borrowers, they, too, are directly under the Fed's interest-rate hammer. Strangely enough, they might be better off if the subprime problems did spill over to the rest of the economy, because then the Fed would be forced to cut rates. As it is, subprime borrowers and other players in the housing market are bearing the brunt of the Fed's inflation-fighting campaign. In fact, the strongest economic argument against Bernanke's stand is that it harms the poor and middle class when inflation is actually well in hand. The Fed's own preferred measure, the price index for personal consumption expenditures excluding food and energy, rose just 1.9% in the year ended June 2007.

But Bernanke fears tight labor markets could reignite inflation. Meanwhile he's alert to signs of a general credit crunch, through his eyes and ears at the market-savvy Federal Reserve Bank of New York. "I don't think the Fed is in the dark on what's happening in the credit markets," says Brian P. Sack, a senior economist at Macroeconomic Advisers who once co-authored a paper with Bernanke.

By order of Congress, the Federal Reserve has a dual mandate, to keep inflation low and employment high. Those seem like not only dual but dueling goals, since putting the screws on inflation can slow growth. But since taking office, Bernanke has argued that the two objectives go hand in hand: In the long run, low inflation promotes stable, job-generating growth. As long as inflation threatens to go above the Fed's threshold, Bernanke believes his No. 1 priority is to keep it down--even if that makes some people unhappy. Clearly, this is one soft-spoken professor who knows how to say no.

Coy is BusinessWeek's economics editor in New York


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