Bernanke's Second Rate Cut

Federal Reserve Chairman Ben Bernanke has upped the ante on his big bet. On Wednesday the Fed cut interest rates for the second time in nine days, reducing the overnight funds rate to 3 percent, down half a percentage point following the three-quarter point cut of last week. The back-to-back cuts are a clear sign that Bernanke is less concerned with threat of inflation than he is with the slowing economy and the ailing banking system.

There's no longer any pretense about fighting inflation. In its statement the Fed said that financial markets "remain under considerable stress" and that recent economic indicators showed "a deepening of the housing contraction as well as some softening in labor markets." As for inflation, it was expected "to moderate in coming quarters."

Well, it hasn't yet. In general the Fed would like inflation in a range between 0 and 2 percent. But for all of 2007 the consumer price index was up 4.1 percent; even without rapidly rising energy and food prices, the increase was 2.4 percent. On the morning of the Fed's rate cut, the Commerce Department released preliminary gross domestic product figures for the fourth quarter. For the entire GDP—the economy's output of goods and services—prices were up 2.6 percent. Prices for consumers were up 3.9 percent. (The broader measure also includes prices for government and business purchases, as well as exports.)

Why is Bernanke turning a blind eye to inflation? He's not, really. Instead he's betting that a sluggish economy in the first half of 2008 will spontaneously dampen price pressures while also justifying the Fed's focus on the financial system and economic growth. The GDP is, after all, a real concern. In the fourth quarter the economy almost came to a halt: GDP increased at a meager 0.6 percent annual rate.

What seems to worry the Fed more than anything is the crippling credit crunch that's hit the financial system—notably banks, investment banks and the buyers of bonds—due to the large losses on subprime-mortgage-backed securities. That bad debt has seeped its way into the nooks and crannies of the financial system and choked off new lending to businesses and households. Without affordable credit the economic downturn could deepen and even be prolonged. "If you listen to banks," says Mark Zandi of Economy.com, "they're concerned that losses on mortgages are broadening to consumer loans and small business loans."

The Fed's remedy is to provide cheaper credit to the banking system in the hope that this will replenish banks' depleted capital and stimulate more lending. The lower Fed funds rate could help in two ways:

First, it has created a "positive yield curve": short-term interest rates are lower than long-term rates. On Wednesday the rate on 10-year Treasury bonds was 3.7 percent, compared with the 3.0 percent Fed funds rate. Banks can borrow at the lower rate, buy T-bonds at the higher rate and profit from the "spread" between the two. The profits help replace lost bank capital. In December the yield curve was inverted. The rate of the 10-year Treasury (4.1 percent) was lower than the Fed funds rate (4.25 percent). Economist Brian Bethune of Global Insight estimates that major banks and investment banks have lost $130 billion on subprime mortgages and that only $30 billion has been replaced by new investment.

Second, the lower Fed funds rate automatically reduces rates on many bank loans—home equity loans, small business loans—that are tied to banks' "prime rate," which usually floats three percentage points above the Fed funds rate. Banks yesterday cut the prime to 6 percent; as recently as mid-September it was 8.25 percent. Lower interest rates ought to reduce future defaults and delinquencies; that would strengthen banks' financial condition and encourage them to make new loans. Lower short-term rates would also cut rates on some adjustable rate mortgages (ARMs) and thereby aid the depressed housing market.

It all sounds logical, but there's one rub. It presupposes that inflation will quietly settle back into the Fed's comfort zone. Perhaps it will. But there's a possible contradiction embedded in Bernanke's game plan: the more successful the Fed is in reviving economic growth, the weaker the anti-inflationary pressures of a sluggish economy will be. The Fed might find itself in the awkward position of having flooded the economy with inflationary amounts of credit. There is at least some skepticism within the Fed itself. Richard Fisher, head of the Federal Reserve Bank of Dallas, dissented from the interest rate reduction. Now it's waiting time. Bernanke has doubled down on his bet. If he succeeds, his reputation should soar. If not, his bad gamble could cost the American economy for years.