Retrospection - Fed's decision to keep rates at 5.25%

Fed Gives Weak Nod to Growth and Credit Risks: Caroline Baum
By Caroline Baum

Aug. 8 (Bloomberg) -- Fed to market: You made your bed, you lie in it.

That was the essence of the Federal Reserve's message yesterday when it left its benchmark lending rate unchanged at 5.25 percent and said inflation remains the ``predominant policy concern.''

Ever since the stock market started to get wobbly in late July, with losses in the Dow Jones Industrial Average exceeding 200 points some days, interest-rate futures markets got it in their head that Fed Chairman Ben Bernanke was going to bail them out.

The message yesterday was: Not so fast. Policy makers gave the weakest possible nod to the volatility in the markets and ``tighter credit conditions for some households and businesses'' without tipping their hand, or their risk assessment, away from inflation.

In the Fed's view, the ``downside risks to growth have increased somewhat'' as the housing correction continues. Inflation in goods-and-services prices is still more troubling than deflation in asset prices (specifically housing). The decline in nationwide home prices has been mild to date, but it is certain to accelerate as the bloated supply of unsold homes comes face to face with reduced demand, with credit-tightening shutting some borrowers out of the market.

The first reaction to the Fed's statement at 2:15 p.m. New York time was to sell. The prices of stocks, bonds, gold and interest-rate futures all went down initially as the Fed failed to corroborate the view that the economic environment was deteriorating rapidly.

Antidote
Until now, ``the Fed has been pretty good at describing the theme people were sensing,'' said Jim Glassman, senior U.S. economist at JPMorgan Chase & Co. in New York. Yesterday's statement ``is out of character with the reality as we know it.''

That doesn't mean the Fed is living in a parallel universe. Policy makers have to differentiate between a financial-market event and a macroeconomic one. For the moment, they have determined that the weakness in residential real estate, the widening of credit spreads and tighter lending standards aren't a threat to economic growth.

The ``cure'' for a period of excess credit is credit restraint: from the Fed; from mortgage lenders, who are faced with rising delinquencies and increased foreclosures on the part of subprime, and now prime, borrowers; and from investors, who are suffering losses on opaque collateralized mortgage and debt obligations that were supposed to diffuse the risk of the underlying loans.

Tainted Inheritance
Bernanke inherited the housing bubble from predecessor Alan Greenspan, who seemed to be rewriting history and offloading some of the blame in yesterday's Wall Street Journal. (Greenspan's greatest problem right now is that his soon-to-be-published memoir, ``The Age of Turbulence,'' may arrive just as the foundation is collapsing.)

He also inherited an institutional burden from his predecessor. Greenspan has been accused of creating a moral hazard, or encouraging risky behavior by putting a floor under the stock market (the ``Greenspan put'').

It may well be that the current Fed chief needs to expiate the sins of the father. Bernanke earned himself the moniker ``Helicopter Ben,'' early on -- unjustly, in my view -- when he compared the Fed's money-creation process to a chopper dropping dollars from the sky.
That's right out of the Milton Friedman teaching toolkit. When was the last time anyone accused the University of Chicago economist and Nobel laureate of fanning inflation?

Base Case
For what it's worth, the Fed's provision of credit, or high- powered money, has slowed to a crawl. The monetary base, which includes currency and bank reserves, grew 2.1 percent in July from the same month a year earlier, according to the St. Louis Fed's database. That's less than the inflation rate. As recently as last year, base money was still growing in excess of 5 percent annually.

There has been some suggestion -- accusation, really -- that the current Fed board is populated with academics (Bernanke along with Fed Governors Frederic Mishkin and Randall Kroszner), and that academics lack Greenspan's innate instincts about the market.
Maybe. Not all of his gut reactions were good ones, however. Greenspan lowered the federal funds rate three times in the fall of 1998 to counter the ``seizing up'' of financial markets in response to the near-collapse of hedge fund Long-Term Capital Management.

The economy didn't miss a beat. Greenspan waited until May 1999 to remove that stimulus. In the meantime, the Nasdaq Composite Index was well on its way to an 86 percent gain for the year.

Gut Check
Greenspan was slow to cut rates when capital spending was imploding in 2000, then did so with a vengeance in 2001. The overnight rate was still at 1 percent when the economy was taking off. Real gross domestic product grew at a 7.5 percent annualized rate in the third quarter of 2003, the start of a three-year trend of strong growth. Yet Greenspan took his time moving the funds rate back to a neutral level.

The Bernanke Fed, with its model-driven forecast, may turn out to be wrong in its laissez-faire attitude toward tightening credit conditions. It will come to that decision in its own way in its own time.

The inverted yield curve, with long-term rates below the Fed's policy rate, has been signaling for almost a year that the Fed is holding the funds rate too high. That disequilibrium is always resolved in favor of lower short-term rates.

I doubt this time will be different. It never is.