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Bernanke May Need To Dig Deeper Into His Toolbox


Federal Reserve Chairman Ben S. Bernanke offered some market-calming words at Jackson Hole, Wyo., on Aug. 31. Perhaps most important, in his first speech since the credit market mess erupted this summer, Bernanke reassured Wall Street that he has a clear understanding of what is happening in the markets and its seriousness. That alone was a confidence booster for the Street's heavy hitters as well as smaller investors. Confidence can be a fleeting thing, though, especially now when the stress level in some markets remains high.

The problem is, any sign of relief from the current tension could be a long time coming. Many have compared this crisis to the 1998 collapse of the big hedge fund Long-Term Capital Management (LTCM). However, that episode basically involved several large banks that lent gobs of money to LTCM, which made some bad bets it couldn't cover—and the crisis was resolved quickly. The current situation is much thornier, and the solution will not likely be as quick or as clean.

This time the housing recession is the eye of the storm. It is hitting both the financial markets and the economy, creating a vicious cycle of interrelated problems that are at once deepening the housing woes while also feeding the credit crisis. Until that cycle is broken, the churning will continue to raise the risk of a broader recession.

The spiral starts with rising defaults on subprime mortgages. They have made many credit market assets backed by such mortgages either worthless or difficult to value. This has all but shut down the riskiest areas of housing finance, which will further depress home demand and construction, and investors' growing aversion to risk is crimping credit availability in other areas of business and consumer finance.

Increasing foreclosures will dump more homes on the market and into an already bloated inventory, which will put additional downward pressure on housing prices. Because falling prices limit refinancing, they create new defaults and foreclosures, and the spiral begins anew. Lower home values also subtract from household wealth, which has supported consumer spending. Thus, the cycle of failed mortgages, tighter credit, housing woes, and a vulnerable economy continues to roil, and the Fed is caught in the middle trying to stem the damage.

BERNANKE'S APPROACH to this turmoil starts with the Fed's two overarching responsibilities: to provide stability to both the financial markets and the economy. Economists at UBS (UBS) recently dug up Bernanke's first speech as a Fed governor in 2002, noting his belief that the central bank has "two broad sets of policy tools" to use in carrying out its "two broad sets of responsibilities." That is, the Fed's regulatory, supervisory, and lender-of-last-resort powers should be used for financial stability, while policy instruments, such as the target interest rate, should be used to achieve the broader economic goals of controlling inflation and ensuring a growing economy.

CLEARLY, THE FED'S ACTIONS so far suggest the policymakers prefer to attack the credit crisis with a barrage of technical actions, such as providing a temporary flood of liquidity, altering the terms and conditions under which banks can borrow directly from the Fed, and other efforts targeted at restoring the proper functioning of the financial markets.

Unless the market turmoil threatens to sink the economy, the Bernanke Fed appears less willing to open the other toolbox, compared with the Fed under Alan Greenspan. That Fed cut rates three times after the LTCM debacle, moves that, some argue, helped fuel the speculation that inflated the tech bubble.

This time the extent of risks to the economy is much more uncertain because of the links among the credit markets, housing, and the economy. Policymakers may have no choice but to take out some recession insurance. Market indicators reflect investors' expectations of at least a quarter-point cut in the 5.25% target rate at the Sept. 18 policy meeting.

The credit markets seem unlikely to be on substantially sounder footing by that date. Although the credit markets appeared to be functioning better in early September, signs of stress were still present, especially in the overseas interbank borrowing markets and in the $1 trillion market for asset-backed commercial paper (ABCP). The volume outstanding fell for the third week in a row as investors continued to shun such mortgage-related paper, bringing the total drop to 15.6%. In early September borrowing rates for ABCP had soared to nearly 6.3%, after holding steady all year at about 5.3%.

Commercial paper finances the day-to-day operations of a large volume of financial sector activity as well as nonfinancial business. As investors run from ABCP to the safety of short-term Treasury debt, many finance companies are unable to secure funding. The failure of the commercial paper market to return to normal suggests the Fed's efforts have been far from effective at alleviating the underlying problem of fear and uncertainty over the value of many credit market assets.

ASIDE FROM THE FINANCIAL MESS, much of the economic data still portray the economy prior to the credit crisis. They generally show solid growth but that's not reassuring for the coming months. New claims for unemployment insurance, while not alarmingly high, rose for the fifth week in a row through Aug. 25, a sign that job markets may be softening, and August consumer confidence dropped, partly over new job worries.

One of the biggest uncertainties in the outlook is the impact of falling home prices on consumer spending. Rising home values in recent years, along with higher stock prices, have helped boost household net worth to record levels. Economists agree that about 4 cents of every additional dollar of household wealth ends up being spent. However, the Fed's published data on household net worth, set to be released on Sept. 13 with numbers for the second quarter, may well be understating the effect of lower home values and thus overstating recent increases in household wealth.

That's because the measure of home prices used in the Fed's estimates, which comes from the Office of Federal Housing Enterprise Oversight (OFHEO) does not include homes with jumbo mortgages, those greater than $417,000, or those with subprime loans. The OFHEO price index in the second quarter was up 2.6% from a year ago, while the Standard & Poor's (MHP) Case-Shiller index, a gauge that is similar in concept but includes homes with all types of mortgages, was down 3.2%. So the housing bust may be having a bigger impact on balance sheets than the official data show.

Bernanke made it clear at Jackson Hole that it's not the Fed's job "to protect lenders and investors from the consequences of their financial decisions." However, those are the decisions now putting the economy at risk. That's why the Fed may have no choice but to reach into its other bag of tools and cut rates broadly, if only to give another boost to investor confidence.

By James C. Cooper


We Almost Lost the Nasdaq
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