FED Watch

Bernanke Weighs Recession Risk Against Investor Cave-In Charge

Sept. 18 (Bloomberg) -- The Federal Reserve will probably cut its benchmark interest rate today for the first time in four years, seeking insurance against a recession. The main question is how big a policy Chairman Ben S. Bernanke is ready to buy.

While a quarter-point reduction in the federal funds rate may not be enough to bolster growth and investor confidence, a half-point cut might fan inflation and be perceived as giving in to pressure from Wall Street firms that made bad bets, especially in the market for securities backed by subprime mortgages.

Bernanke and fellow policy makers ``are really caught,'' said Robert Eisenbeis, a former research director at the Fed's bank in Atlanta who attended meetings of the rate-setting Federal Open Market Committee before retiring early this year. ``The Fed needs to avoid the perception of bailing out the markets, lenders or borrowers.''

The FOMC will opt today for a quarter-point cut to 5 percent in the rate that banks charge each other for overnight loans, according to the median prediction of 134 economists surveyed by Bloomberg News. Twenty-three of the forecasters projected a half-point move, which traders think is coming sooner or later: Interest-rate futures indicate a rate of 4.5 percent by year-end. The decision is scheduled for about 2:15 p.m. in Washington.

Most-Analyzed Statement

Whatever today's decision, the statement accompanying it may be the most-analyzed in years. Reports portray a weakening economy: The Labor Department said Sept. 7 that that the U.S. last month suffered its first job losses since 2003. Investors will look for hints of further cuts -- such as a pledge to act as needed to safeguard the six-year expansion -- or language that plays down the risk of higher inflation.

``The markets will be disappointed by 25 basis points,'' said Joseph LaVorgna, chief U.S. economist at Deutsche Bank Securities Inc. in New York. ``If they do more now, they may be more cautiously optimistic in the statement. If they do 25 basis points, they will commit to doing more. You can argue it either way for which is the more powerful.''

The Fed's decision today will come hours after the government report on August wholesale prices; the Consumer Price Index is released tomorrow. As recently as the last FOMC meeting Aug. 7, officials said inflation was the ``predominant'' risk to the U.S. economy.

Just 10 days later, the Fed acknowledged that ``downside risks to growth have increased appreciably'' and pledged to ``act as needed.'' Policy makers will probably use similar language today, economists said.

`A Considerable Amount'

``The statement will point to the growth rate as the predominant policy influence and give the market the flexibility to price in a considerable amount of easing,'' said Brian Sack, vice president at Macroeconomic Advisers LLC in Washington and a former Fed economist.

Bernanke, 53, and his team may take additional steps to increase liquidity, including lowering the discount rate --which the fed charges on loans it makes to banks -- or altering terms for collateral used for loans from the central bank, economists said.

In their public comments, Fed officials have diverged in their assessments of risks to growth, making today's meeting particularly tough for analysts to handicap.

Since the August jobs report, Fed Governor Frederic Mishkin and San Francisco Fed President Janet Yellen have highlighted threats to consumer spending. By contrast, Fed bank Presidents Richard Fisher in Dallas and Charles Plosser in Philadelphia noted signs of resilience in the economy.

No Cave-In

At the same time, all agree the Fed doesn't want to be seen as caving in to funds that piled into the market for securities linked to subprime mortgages, those made to borrowers with poor or limited credit histories.

As defaults on such loans climbed, investors fled, making it tough for some companies to obtain credit; the market for asset-backed commercial paper shrank the most in at least seven years.

``It is not the responsibility of the Federal Reserve --nor would it be appropriate -- to protect lenders and investors from the consequences of their financial decisions,'' Bernanke said in an Aug. 31 speech in Jackson Hole, Wyoming.

Anything seen as a bailout might increase ``moral hazard'' -- spurring investors to take on even more risk, comfortable in the belief the Fed will make good their losses.

Rivlin Regrets

Former officials including Alice Rivlin, who was a Fed vice chairman under Bernanke's predecessor Alan Greenspan, have expressed regret over cutting rates three times in 1998. The economy continued to expand with little harm from turmoil in financial markets at the time, data later showed.

``The moral hazard argument is a powerful one,'' said Philip Orlando, who helps manage $260 billion as chief equity market strategist at Federated Investors Inc. in New York. As a result, he predicted, ``the market is wont to be disappointed'' by today's decision.

Others say policy makers will focus more on the recent economic data showing signs of a sputtering economy. Besides the decline in August payrolls, retail sales and industrial production rose less than forecast last month, and the Commerce Department may say tomorrow that builders broke ground on the fewest new homes since 1995.

Bernanke and fellow policy makers ``are trying to step away from the Greenspan model,'' said Diane Swonk, chief economist at Mesirow Financial Inc. in Chicago. ``But at the end of the day, they will act the same.'' 

Greenspan's Miscues Haunt Bernanke as Fed Weighs Cut

Sept. 17 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke is grappling with what predecessor Alan Greenspan might call a conundrum.

At issue is whether today's U.S. economy most resembles 1998, when Greenspan may have been too eager to cut interest rates, or 2000-2001, when he may have been too slow. The trouble is, the situation now resembles a bit of both.

That increases the danger as the Fed's Open Market Committee meets tomorrow to decide on interest-rate policy. If Bernanke and his colleagues aim to avoid the mistake of 1998 and opt for caution, they risk a recession. If they push ahead with big rate cuts and growth proves resilient, they could find themselves with rising inflation, fueled by record oil prices and a slumping dollar.

``This is a critical time for the Fed,'' says Peter Hooper, who worked at the central bank during the financial crisis in 1998 and is now chief U.S. economist for Deutsche Bank Securities in New York. ``The stakes have risen.''

The Fed today faces a financial-market-driven increase in borrowing costs, as in 1998, and a weakening economy comparable to 2000. The central bank responded to the former with three rapid-fire rate cuts, which some officials now think helped inflate the stock-market bubble. In 2000, it made the opposite mistake after the bubble burst, waiting too long to cut rates and allowing the U.S. to fall into recession.

Template for Action

Which model the Fed latches onto will help determine whether it reduces the federal funds rate tomorrow by a quarter or a half percentage point. If 1998 is the guide, policy makers may settle for the smaller cut. Taking a cue from the 2000 episode would suggest a half-point drop in the rate, which is charged on overnight loans between banks.

Judging by their public comments, policy makers are divided over which path to follow. Futures trading indicates investors expect at least a quarter-point cut.

For J. Alfred Broaddus Jr., who helped fashion policy in both 1998 and 2000 as Richmond Fed president, today's situation ``is more comparable to 2000 and 2001. There is a clear risk to the economy.''

Gross domestic product grew at an average annual rate of 2.3 percent in 2007's first half, and economists surveyed by Bloomberg expect that pace to continue through the end of the year. In 1998, the economy expanded 4.2 percent.

`A Little Slow'

Broaddus says the Fed underestimated the economic impact of the stock market slide that began in March of 2000 and eventually dragged the Standard & Poor's 500 index down more than 25 percent. ``We were a little slow to get under way'' with rate reductions, he says.

This time, Fed officials have been surprised by the severity of the housing decline and the damage it has wreaked on the rest of the economy. Minutes of the FOMC's Aug. 7 meeting show policy makers judged that the housing slump ``could well prove to be both deeper and more prolonged than had seemed likely earlier this year.''

Having left rates unchanged at that meeting, the Fed changed course 10 days later, lowering the discount rate --what it charges on direct loans to banks -- and acknowledging that risks to the economy had risen ``appreciably.'' The surprise move led investors to increase bets on a cut in the more- important fed funds rate at tomorrow's meeting.

Greenspan's Endorsement

Greenspan endorses his successor's handling of the market turmoil so far, saying in an interview with CBS television that he is ``not certain I would have done anything different.''

Even so, the Fed ``has been very slow to acknowledge what is one of the biggest busts in U.S. housing history,'' says Allen Sinai, president of New York-based Decision Economics Inc.

What eventually helped push the Fed to cut rates at the start of 2001 was a sharp drop in consumer confidence, recalls Tom Simpson, a former senior official at the bank. As measured by an index compiled by the University of Michigan, confidence fell to a two-year low in December 2000.

Confidence is also depressed this year, reaching its lowest level in a year in August and remaining close to that point in early September.

Fed officials say they are well aware of the dangers that a sudden drop in confidence could pose if it led to a pullback in household and business spending.

`Important' Risk

``I believe it poses an important downside risk,'' Fed Governor Frederic Mishkin said in a Sept. 10 speech in New York.

Simpson, who retired from the Fed in 2006 after 30 years and is now at the University of North Carolina at Wilmington, sees another parallel with 2000: Monetary policy is restricting the economy after credit tightening by the central bank.

The Fed raised its target for the federal funds rate to 6.5 percent in May of 2000 from 4.75 percent in June of 1999. The rate now stands at 5.25 percent, up from 1 percent in mid-2004.

Deutsche Bank's Hooper sees a danger of recession if the Fed is too cautious in cutting rates.

In remembering the lessons of 2000 too well, though, the central bank would risk losing ground in its fight to keep inflation contained.

``Rate cuts are not free,'' says Marvin Goodfriend, senior vice president at the Richmond Fed from 1993 to 2005 and now a professor at Carnegie Mellon University in Pittsburgh. ``You pay a price.''

Consider TIPS

The inflation risk makes it a good time for investors to consider Treasury Inflation Protected Securities, says James Evans, who manages $4 billion of inflation-linked bonds at Brown Brothers Harriman & Co. in New York. ``The TIPS market is poised to do pretty well,'' he says.

Laurence Meyer, a Fed governor from 1996 to 2002, cautions against giving too much weight to comparisons with 2000. He remembers hearing plenty of anecdotes back then about a slowing economy. Today, the weakness appears more narrowly focused on housing.

A regional Fed survey released Sept. 5 found the economic effects of the August credit market rout ``limited'' outside of housing.

``Our economy appears to be weathering the storm thus far,'' Dallas Fed President Richard Fisher said in a Sept. 10 speech in Laredo, Texas. ``As yet, tighter credit conditions do not appear to have had a major impact on overall economic activity outside of real estate.''

Greenspan acknowledges that the Fed risked fanning inflation when it lowered interest rates in 1998. Yet he argues in his just-released book, ``The Age of Turbulence,'' that the chance was worth taking to keep the crisis from dragging down the economy.

Others who were policy makers at the time are not so sure. Meyer, now vice chairman at Macroeconomic Advisors LLC in Washington, says the lesson of that year is that ``it's very hard to judge the linkages between the financial markets and the economy,'' he says. ``You can over-react.''

To contact the reporter on this story: Rich Miller in Washington