By Craig Torres
Sept. 13 (Bloomberg) -- Alan Greenspan trusted his instincts. Ben Bernanke trusts the MAQS.
For the past several days, the MAQS -- a group of analysts in the Federal Reserve's Macroeconomic and Quantitative Studies unit -- have run a series of what-if scenarios on the U.S. economy that will play a critical role in next week's interest- rate decision.
The simulations will supplement the forecast handed to policy makers at the start of their Sept. 18 meeting and may determine the size of the rate cut almost universally predicted by Wall Street economists.
Bernanke has championed the team's work since becoming Fed chairman in 2006 because he wants to sift through models, projections and anecdotes before coming to conclusions. His approach contrasts with that of predecessor Alan Greenspan, who relied more on his own reading of conditions -- and as a result probably would have cut rates to insure against a recession long before the Sept. 18 Federal Open Market Committee gathering.
``Greenspan emphasized that, in response to a low- probability but high-cost outcome, the Fed should move aggressively,'' said Mickey Levy, chief economist at Bank of America Corp. in New York. ``This Fed under Bernanke is more disciplined.''
The FOMC will next week lower the overnight lending rate between banks to 5 percent from 5.25 percent, according to the median forecast of economists surveyed by Bloomberg News. The reduction would be Bernanke's first and may be followed by at least two more before year-end, federal funds futures suggest.
Calls for lower borrowing costs have been mounting since early August as the collapse of the subprime-mortgage market suddenly raised the cost of credit for companies and consumers. Pressure on Bernanke increased even more after a Labor Department report on Sept. 7 showed employers got rid of workers last month for the first time in four years.
Rather than resort to an emergency cut in the federal funds rate, Bernanke, 53, has waited for more data and a careful study of all the scenarios now under preparation by the staff.
The MAQS are in charge of the quantitative model of the U.S. economy known as FRB/US or ``Ferbus.'' By adjusting for such things as higher financing rates for American companies or a sharp decline in home prices, the team provides policy makers a glimpse of possible outcomes.
The scenarios -- known at the Fed as ``alt sims'' or alternative simulations -- are especially important at next week's meeting because the vote will likely be cast on the dangers that the forecast is better or worse than reported, former Fed officials said.
``The FOMC will start by looking at the standard calculation'' of how changes in home prices and credit spreads affect the outlook for employment and inflation, said Douglas Elmendorf, an assistant director of the Federal Reserve Board's research and statistics division from 2004 to 2007.
Policy makers will then ask, ```Where do we see the risks arrayed around the baseline?''' said Elmendorf, now a senior fellow at the Brookings Institution in Washington. ``Alternative simulations are quite important, particularly because of the Fed's announced interest in risk management.''
The methodical approach has some pining for the good old rapid-response days of Greenspan, who called six emergency rate meetings between 1992 and 2001. Five of those resulted in reductions as he sought to head off recession or ease gridlock in capital markets.
`Slow to Acknowledge'
Under Bernanke, ``the Federal Reserve has been very slow to acknowledge what is one of the biggest busts in U.S. housing history,'' said Allen Sinai, president of Decision Economics Inc. in New York. ``They've never even called it a recession.''
The distinction between Bernanke and Greenspan, 81, has roots in their different resumes and competing views about managing risk and uncertainty. Greenspan was a business economist before he became Fed chairman in 1987 -- one of his offices was on Wall Street -- and he read the economy like an income statement. His decisions were often based on close readings of disparate data, and his methods defied quantification. Greenspan's memoirs of his years at the Fed will be released on Sept. 17, the eve of the rate decision.
Bernanke, a former head of the economics department at Princeton University, has spent most of his career in academia. His analysis is based on models, and he has greater confidence in forecasts and statistical methods.
Over time, Greenspan's ``confidence in making snap judgments on less convincing evidence increased,'' said Ethan Harris, chief U.S. economist at Lehman Brothers Holdings Inc. in New York. ``Bernanke has a more balanced approach to decision making, which means you combine business-economist skills with anecdotes, high-frequency indicators, with models and simulation exercises.''
Both approaches have risks. Greenspan cited uncertainty as ``the defining characteristic'' of the monetary policy landscape in an August 2003 speech. ``Only a limited number of risks can be quantified with any confidence,'' he said.
The speech was critical of models, and elevated the role of judgment. He invoked theories of Frank Knight, a University of Chicago economist from 1927 to 1955, to explain his ideas of risk management.
Knight distinguished between risk and uncertainty: Risk is quantifiable, uncertainty is random. Managers ``would try to turn those uncertainties into knowable costs,'' said Ross Emmett, a professor at James Madison College at Michigan State who has edited a collection of Knight's essays. ``They would purchase insurance.''
Greenspan's preference for insurance was most visible in the third rate cut of 1998, and the aggressive easing from 2001 to 2003 to offset a ``minor'' probability of deflation.
Both those moves have been reassessed by Fed officials and private economists, who acknowledge that the rate cuts were too aggressive. To use Greenspan's framework, the Fed ``overpaid'' for insurance against risks that turned out to be less severe.
``We did use the fed funds rate, and that may have been a mistake,'' former Fed Vice Chairman Alice Rivlin, who voted for the 1998 rate cuts, said in an interview last month. Referring to the Bernanke Fed, she added: ``It might have been smarter to try what they are trying.''
The third cut of 1998 took the federal funds rate to 4.75 percent in a quarter when the economy grew at a 6.2 percent annual rate, according to revised data. In 1999, the Nasdaq Composite Index surged 86 percent, only to lose 39 percent the following year, and another 21 percent in 2001.
Bernanke, as a Fed governor, voted to keep the federal funds rate below consumer-price inflation for three years from 2002 to 2004. The result was a different bubble -- housing -- fueled by the biggest mortgage binge on record. Americans borrowed $2.8 trillion in home loans between 2004 and 2006.
``It was the Fed's own lax monetary policy that permitted the problem to arise,'' said Anna Schwartz, co-author of the 1963 book ``A Monetary History of the United States, 1867-1963'' with Nobel laureate Milton Friedman. ``The responsibility is right at the door of the Federal Reserve.''
Statistical modelers such as Bernanke have their own icon to draw on: the 18th century British mathematician and Presbyterian minister Thomas Bayes. Unlike Knight's apostles, Bayesians are more likely to quantify uncertainty by deriving probabilities. There is also a role for constant updating with new information to hone a forecast. Bayesian theory is used in hurricane tracking, for example.
Speeches suggest that members of the current FOMC are aware of the danger of overpaying for insurance again.
``Conditions can change quickly for better or for worse, especially in financial markets, so it's hard right now to speak with a great deal of confidence about future economic developments,'' San Francisco Fed President Janet Yellen said Sept. 10.
``A good example is the aftermath of the Russian debt default in 1998,'' she said. ``Many forecasters predicted a sharp economic slowdown as a result, but instead, growth turned out to be robust.''
Last Updated: September 13, 2007 00:04 EDT