Monday, December 10, 2007

Bernanke May Risk `Fool in the Shower' Label to Avert Recession

By Rich Miller

Dec. 10 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke may have to risk becoming the proverbial ``fool in the shower'' to keep the U.S. economy out of recession.

Renewed turbulence in financial markets puts Bernanke, 53, under pressure to open the monetary spigots wider to pump up the economy. Traders in federal funds futures are betting it's a certainty the Fed will cut its benchmark interest rate from 4.5 percent tomorrow, and they see a better-than-even chance the rate will be 3.75 percent or below by April.

``The Fed has to assure the markets that it's ready to ride to the rescue and cut rates by as much as necessary,'' says Lyle Gramley, a former Fed governor who's now a senior economic adviser in Washington for the Stanford Group Co., a wealth- management firm.

The danger of such a strategy is that Bernanke may become like the bather, in an analogy attributed to the late Nobel- Prize-winning economist Milton Friedman, who gets scalded after turning the hot water all the way up in a chilly shower. The monetary-policy equivalent would be faster inflation or another asset bubble in the wake of aggressive Fed action to tackle the slowdown in the economy.

Bernanke opened the door to a rate cut at tomorrow's meeting when he signaled in a speech on Nov. 29 that the market turmoil had led to tighter credit conditions that might slow economic growth.

`Something More'

``The odds of something more than a 25 basis-point cut in the funds rate are pretty good,'' says Louis Crandall, a former New York Fed official and now chief economist at Wrightson ICAP LLC, a Jersey City, New Jersey-based bond research firm.

He expects the Fed to twin a quarter percentage-point cut in the funds rate, charged on overnight loans between banks, with a half-point reduction in the Fed's 5 percent discount rate. That's the rate the central bank charges on its direct loans to commercial banks.

Narrowing the difference between the two might encourage more banks to borrow from the Fed and help relieve some of the stress in the money markets.

Former Fed Governor Lawrence Meyer, who also expects a quarter-point cut in the funds rate, says the central bank needs to signal in its statement after the meeting that it's open to doing more.

Market Confidence

``It would damage the market's confidence if they don't,'' says Meyer, now vice chairman of economic forecaster Macroeconomic Advisers LLC in St. Louis. ``You don't want to send a message that we'll only ease policy over our dead bodies.''

Money-market interest rates have jumped during the last month as lenders hoarded cash to buttress year-end balance sheets. Also driving rates up: concerns about losses on securities linked to mortgages at risk of default. The rate on three-month loans between banks rose to 5.14 percent on Dec. 7 from 4.9 percent Nov. 7.

The credit squeeze poses a double-barreled risk for the economy. In the short run, there's the danger that a major institution might encounter financing problems before the end of the year.

``The risk of a financial accident is vastly greater than it was three months ago,'' says Crandall, whose firm is a unit of ICAP Plc, the world's largest broker for banks and other financial institutions. ``A lot of firms are running on Plan C in dealing with the turmoil, and they don't have a Plan D.''

Risk-Free Haven

Fears of such a shock have sent yields on Treasury debt lower, as investors seek the haven of risk-free securities. The yield on the two-year Treasury note was 3.1 percent on Dec. 7, down from 3.5 percent a month earlier.

The longer-run risk, says Richard Berner, chief U.S. economist at Morgan Stanley in New York, is that tighter credit will slow growth by making borrowing more difficult and expensive.

Almost one-third of 573 chief financial officers surveyed by Duke University and CFO Magazine last month reported their companies had been hurt by the credit squeeze. Of those, close to half said they had less access to loans. Almost as many reported borrowing costs had jumped.

While Bernanke has cut interest rates by three-quarters of a percentage point since mid-September, his approach so far has been more calibrated than that of his predecessor, Alan Greenspan, in 2001. Greenspan, 81, cut rates by 1.5 percentage points in the first quarter of 2001 in an ultimately unsuccessful effort to head off a recession.


``They're trying to go through an experiment in which they don't follow the classic policy response of overdoing it on interest rates,'' says Michael Feroli, a former Fed official who is now an economist with JPMorgan Chase & Co. in New York.

That's the mistake made by the ``fool in the shower,'' a metaphor attributed to Friedman in ``Principles of Economics,'' a textbook by Karl Case of Wellesley College and Ray Fair of Yale University. Friedman wrote in 1960 that monetary policy is subject to ``long and variable'' lags that make it tricky to predict the outcome of a decision.

Bernanke's more measured approach may, in part, be born of necessity. As Greenspan himself acknowledged in his book, ``The Age of Turbulence,'' he benefited as Fed chief from the disinflationary forces of globalization and faster productivity growth. Bernanke, who took over in February 2006, hasn't been so fortunate.

Cruising Speed

Oil prices have tripled since January 2001. The dollar, on a trade-weighted basis, is about 20 percent lower. The federal budget, running a surplus in 2001, is now in deficit. And Fed officials such as San Francisco Fed President Janet Yellen now peg the noninflationary cruising speed of the economy at an annual rate of roughly 2.5 percent. That compares with more than 3 percent back in 2001.

Bernanke also doesn't enjoy the same stature Greenspan did during his closing years atop the central bank. That means Bernanke is more likely to face opposition from other policy makers if he tries to push through a half-point cut in the federal funds rate tomorrow.

``I wouldn't rule out a half-point cut,'' Gramley says. ``But it's more likely they'll compromise on a quarter point and a wide-open statement. ``

Harvard University economist Martin Feldstein suggested in a Dec. 5 interview that the Fed shouldn't stop there.

``We're seeing an economy that is continuing to slip and therefore an increasing probability of a recession next year,'' he said. ``The Fed has to be prepared to continue cutting rates as we go into 2008; and it shouldn't be afraid if before the year is over, if the economy is weak, they're down to a number like 3 percent.''

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