Published in the Los Angeles Times on January 11, 2008 By Peter G. Gosselin
Professor at the Brandeis International Business School
Fed Chairman's Speech Signals Steep Rate Cuts
WASHINGTON -- Federal Reserve Chairman Ben S. Bernanke, acknowledging that slumping employment and continued turmoil in financial markets pose mounting threats to the U.S. economy, said Thursday that the central bank may be ready to make "substantive" interest rate cuts to avoid recession.
Bernanke's comments in a speech in Washington suggested that the Fed would slash its key target interest rate by half a point from its current 4.25% when it meets this month. And it could make further steep cuts in the months to come.
Such aggressive rate-cutting was precisely what Fed policymakers had appeared unwilling to do this fall. In September, they made a half-point cut, followed by two quarter-point reductions as they pondered how serious the economy's problems were and explored other means of coping with them.
But Thursday, Bernanke appeared to side firmly with those who believe that the economy is in serious trouble and that the central bank may have to take more vigorous steps.
The outlook "for real activity in 2008 has worsened, and the downside risks to growth have become more pronounced," Bernanke said, adding that "additional policy easing may well be necessary."
"We stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks," he said.
Bernanke has been under considerable pressure to act. In recent weeks, President Bush and leading congressional Democrats have hinted they were preparing economic stimulus packages. The Fed chairman also has been the target of a steady stream of invective from Wall Street, where investors say he does not fully appreciate the danger they face.
And as the presidential campaign accelerates, so will the outpouring of fix-it proposals to calm volatile markets, deal with the housing market meltdown and get the economy back on track without kindling inflation.
In his speech, Bernanke gave a nod to inflation concerns, saying escalating food and energy prices could set off a destructive general rise in prices. Although he said Americans' expectations of inflation "have remained reasonably well anchored," he added that "any tendency of inflation expectations to become unmoored or the Fed's inflation-fighting credibility to be eroded could greatly complicate" the central bank's job.
The Fed chairman's new warning about inflation reflected the fact that, even as the economy appears to be slowing, it is also showing some signs of a potential price surge -- the worst of both worlds for economic policymakers. Most measures of inflation show prices increasing faster than the 1.5%-to-2% range that the Fed considers its comfort zone, even as growth slows from its July-to-September pace.
Still, the Fed chairman devoted most of his speech to signs of growing economic weakness, suggesting that he now sees this as the bigger threat. The rest of the Fed's policymaking Federal Open Market Committee may say as much when it meets Jan. 29 and 30.
Bernanke labeled as "disappointing" last Friday's employment report for December, which showed that the unemployment rate had climbed to 5% from 4.7% in November and that private payroll employment had dropped.
Although he cautioned against reading too much into one month's report, he added, "should the labor market deteriorate, the risk to consumer spending would rise," a significant threat given that consumers account for about 70% of economic activity.
"This speech tells me that [Bernanke] has become more concerned about financial market disruptions having an effect on the real economy," said Stephen G. Cecchetti, an economist at the Brandeis International Business School and former research director of the Federal Reserve Bank of New York.
The Fed "tried to ring-fence the financial market problems from the economy and it's not working," Cecchetti said. Bernanke no longer believes the financial market and economic problems can be treated separately, and thinks the Fed must be ready to make substantial rate cuts to keep the economy from stalling out, he said.
Economists at Goldman Sachs, the New York-based investment bank, predicted Wednesday that the Fed would cut the federal funds rate to 2.5% by the end of 2008. And they joined their counterparts at Merrill Lynch & Co. and Morgan Stanley in forecasting that the economy would slide into recession.
Home construction and new-home sales have plunged by half from their peaks, and the Fed is predicting that it may take six more months for the housing market to catch up. Delinquency rates on sub-prime mortgages, loans to less creditworthy borrowers, hit a decade-high of 16.3% in the third quarter.
"The demand for housing seems to have weakened further, in part reflecting ongoing problems in mortgage markets," Bernanke said. "We also see considerable evidence that banks have become more restrictive in their lending to firms and households," which carries the threat of recession.
In Europe, though, inflation fears seem to be winning out over concerns of an economic slowdown. On Thursday, the European Central Bank and Bank of England held rates steady.
The ECB's Governing Council discussed raising rates from 4%, but a rate cut was not part of the debate, President Jean-Claude Trichet said at a news conference. European shares fell to their lowest point this year after the ECB comments.
The Bank of England also kept rates unchanged after making a cut in December. British retailers are worried by signs of a slowdown in consumer spending and were disappointed by the decision. The British Retail Consortium had urged the bank to cut rates again.
Stephen G. Cecchetti is the Barbara '54 and Richard M. Rosenberg Professor of Global Finance at Brandeis International Business School, and Research Associate, National Bureau of Economic Research. He is a regular contributor to the Financial Times.