From the Sunday, September 23, 2007 Sunday Times (London)
September 24, 2007
by Irwin Stelzer
One and done. That’s what some commentators are saying about the decision of the Federal Reserve Board’s monetary policy committee to cut the federal funds rate by half a percentage point. They reason that Chairman Ben Bernanke had a choice between doing too much, too soon, or too little, too late - and chose the former.
Both options have risks. Cut rates and he might unleash inflation by stimulating an economy that is already growing at a reasonable pace. And he might create that bane of all central bankers, moral hazard, by bailing out improvident lenders and borrowers.
But too little, too late also contained risks. Financial markets are, to put it mildly, nervous. Credit is not easy to come by; Americans were watching lines of panicked depositors forming at Northern Rock branches, demanding their money; some mortgage-related institutions were already in bankruptcy or on the brink of it; and next year’s rise in teasingly low initial mortgage rates threatens tens of thousands of homeowners with foreclosure.
“The turbulence originated in concerns about sub-prime mortgages, but the resulting global financial losses have far exceeded even the most pessimistic estimates of the credit losses on these loans,” Bernanke told Congress two days after reducing the federal funds rate from 5.25% to 4.75%. Better to be a bit too generous, even with the attendant risks, than to fail to lower rates enough to forestall a possible cataclysm in financial markets and the real economy. So holds Bernanke.
Although the “one and done” crowd thinks Bernanke might have headed off inflation by hinting that he will not cut rates further, it is not clear that they are right. If economic conditions deteriorate, last week’s cut might prove to be the first of many: some forecasters are saying that the federal funds rate will fall to 4.0% by the first quarter of 2008, and to 3.5% by this time next year.
More important, it is not clear that the economy is so soft that it can absorb this stimulus without an increase in inflation. New data suggest that the jobs market is stronger than the earlier jobs report led us to believe. Earnings remain good, even at the troubled investment banks. Retail sales are not all shopkeepers would like, but back-to-school and luxury goods have moved smartly off the shelves. Exports are rising at an annual rate of about 15%. Oil and other commodity prices are rising, as are labour costs. The world economy is growing. All of this has added to fears that Bernanke, who once joked that the way to end a recession is to toss money from helicopters, has won instant popularity by stoking up future inflation.
The markets are indeed worried. The price of gold, considered an inflation hedge, is soaring. Long-term interest rates are up, as investors fear the value of their investments will be eroded by inflation, and demand higher returns. The dollar’s drop is accelerating, as investors anticipate its progressive devaluation. The inflation genie might still be bottled up, but Bernanke has loosened the cap on that container.
But the genie has not popped out, at least not yet. Shortly after Bernanke’s rate cut, the government reported that consumer prices fell in August: so much for inflation fears. Housing starts dropped to 42% below their January 2006 peak, a 12-year low, and the National Retail Federation is predicting a less-than-jolly Christmas season: so much for fears of an overheating economy.
Most important to fans of the Bernanke move, credit markets are beginning to function more normally. Corporate borrowers suddenly find capital markets open. Lehman Brothers Holdings and General Electric immediately sold bonds, and RH Donnelley floated more than $1 billion in junk bonds, the first such sale since the credit crunch began in August. Deal-makers emerged from their funk as the prospects for financing the backlog of transactions improved. After “a quiet period in new transactions through the first quarter of 2008”, said Goldman Sachs’s head of merchant banking, Rich Friedman, deals will pick up, but they will be smaller and less lucrative.
Lessons have been learnt, or should have been.
- At least for the foreseeable future, lenders are unlikely to throw money at the penurious homeless or firms dependent on that group. But remember: bankers have famously short memories.
- Pragmatic activism trumps academic dithering. Bernanke’s hero status contrasts sharply with that of his British counterpart, Mervyn King. The governor of the Bank of England held stubbornly to his anti-moral-hazard, hands-off policy. Panic ensued, and his government was forced to stem a bank run by guaranteeing bank deposits. Talk now centres on when, not whether, King will be forced to resign. The contrast between Bernanke’s popularity and King’s likely fate will not be lost on central bankers.
- Ideology is a poor guide to policy during periods of financial difficulty. The Bush administration resisted efforts to ease conditions in mortgage markets, but had to beat a partial retreat in the face of criticism from Democrats in Congress.
- Most financial institutions in America are in good shape. The recent period of illiquidity had an impact, but no major bank was threatened with collpase.
When all is said and done, we are once again driven back to the commentator Walter Bagehot, who noted during the monetary crisis of 1857: “That panics will occur every now and then . . . it is impossible to question . . . In America . . . we cannot reasonably anticipate anything but an occasional repetition.” Bernanke has no reason to fear boredom once the current crisis has passed.
Irwin Stelzer is a Senior Fellow and Director of Economic Policy Studies for the Hudson Institute. He is also the U.S. economist and political columnist for The Sunday Times (London) and The Courier Mail (Australia), a columnist for The New York Post, and an honorary fellow of the Centre for Socio-Legal Studies for Wolfson College at Oxford University. He is the founder and former president of National Economic Research Associates and a consultant to several U.S. and United Kingdom industries on a variety of commercial and policy issues. He has a doctorate in economics from Cornell University and has taught at institutions such as Cornell, the University of Connecticut, New York University, and Nuffield College, Oxford.
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