Ben Bernanke's Big Gamble

Call it Ben's big gamble. Traditionally, the Federal Reserve has had two main goals: suppressing inflation and preventing financial panic. Since August the Fed has tried to juggle the two, providing enough new money and credit so that financial markets work smoothly without providing so much that inflation picks up. The Fed's straddling has subjected chairman Ben Bernanke to intense criticism. Some have charged that the Fed was behind the curve and that Bernanke, a former Princeton economist, was out of touch with the markets. Well, on Monday Bernanke capitulated. The Fed cut its key interest rate from 4.25 percent to 3.5 percent and hinted that further rate cuts might come as early as next week.

The Fed's surprise move didn't win Bernanke many fans during Wall Street's early hours of trading. At its worst, the Dow was down 3.8 percent today. The market rebounded, but the Dow ended the day at a 14-month low, the S&P at a 16-month low and the NASDAQ at its lowest level in 15 months. Today's turmoil comes on the heels of a massive sell-off in world stock markets on Monday. (U.S. exchanges were closed for the Martin Luther King Jr. holiday.) Germany's market was down 7.4 percent, Japan's 3.9 percent and Britain's 5.5 percent.

The Fed's 75 "basis point" cut was the largest since the Fed began explicitly targeting interest rates in the early 1990s. By making the adjustment the Fed is betting that monetary policy will stabilize the U.S. economy and, by extension, global markets. But the gamble is profound. It assumes that the slowing U.S. economy will automatically dampen price and wage pressures so that cheaper money won't trigger an inflationary spiral. Economist William Poole, president of the St. Louis Fed, dissented, indicating that some officials believe the Fed is making a bad bet.

Until last summer the Fed was concerned mostly with fighting inflation. Since June 2006 the overnight Fed funds rate had been at 5.25 percent, the highest level since March 2001. But then the rapid deterioration of the housing market increased the odds of a recession and resulted in large losses on "subprime" mortgage-backed securities. Citigroup, Merrill Lynch and Bear Stearns all suffered big losses, fanning fears of a "credit crunch" as lenders and investors cut back on new commitments. The subsequent cuts in the Fed funds rate aimed to ease those fears by lowering borrowing costs for banks and other financial institutions. Up to a point the medicine worked, but in the past few days confidence in global financial markets "deteriorated at electrifying speed," as economist Roger Kubarych of UniCredit puts it.

What's extraordinary about this is that, although most forecasts show a weakening economy, few yet suggest anything like a dramatic collapse. For example, in its latest forecast Deutsche Bank projects that the U.S. gross domestic product will grow 2.2 percent in 2008, the same as in 2007. To a large extent the Fed and Bernanke seem to be fighting a self-fulfilling loss of confidence that could turn an otherwise mild slowdown—or recession—into something worse. If consumers and investors lose confidence, they'll retreat from both shopping malls and stock markets. Former Fed governor Laurence Meyer of Macroeconomic Advisers thinks the Federal Open Market Committee will cut rates again next week at its regular January meeting.

Still, Bernanke's gamble isn't guaranteed to succeed. Since World War II the Fed's greatest blunder was to unleash double-digit inflation. In 1960 consumer prices rose 1.4 percent; in 1979 the increase was 13.3 percent. With hindsight it's clear that Fed policies were too loose, creating too much money chasing too few goods. But that was not so apparent at the time, when the Fed responded to public pressure to minimize recessions and keep unemployment down. It loosened money and credit, and the effects on inflation showed up a couple of years later. There was a steady upward creep; that is the risk Benanke is now running.