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Published September 4, 2007

All Bernanke did was maintain market's uncertainty

His mixed signals stem from need to protect real economy and prevent moral hazard

By LEON HADAR
WASHINGTON CORRESPONDENT

ECONOMIC analysts seemed to have raised expectations to the stratosphere on the eve of the speech that the Federal Reserve chairman Ben Bernanke was scheduled to deliver at the Federal Reserve Bank of Kansas City's annual symposium in Jackson Hole, Wyoming, last Friday.

Some of them described the address as the most important event in Mr Bernanke's 19 months as America's central banker, suggesting that his most extensive comments since the credit crunch took a turn for the worst in the last month could have huge effect on the financial markets and by extension, on the American and global economies.

The head of the world's most powerful central bank, whose job is to help provide stability to the financial markets and control inflation and ensure that economic growth remains healthy, would have to play a very difficult balancing act, the pundits argued.

He had to refrain from projecting a sense of benign neglect towards the chaos in the financial markets that could create even more turmoil on Wall Street with a devastating impact on the broader economy.

At the same time, if Mr Bernanke were to create the impression that the Fed was going out of its way to bail out the investors that were being punished for their irresponsibility, he could be creating a 'moral hazard', that is, the US central bank would be seen as providing these greedy investors with incentives to repeat their disastrous conduct in the future.

The conventional wisdom on Wall Street until recently has been that the policies adopted by Mr Bernanke's predecessor Alan Greenspan had succeeded in achieving both of these goals of the US central bank. Mr Greenspan's decisions to cut interest rates in the aftermath of the stock market crash of 1987 and the collapse of the Long-Term Capital Management (LTCM) hedge fund helped give a needed financial lift to investors, preventing a potential disaster on Wall Street, and at the same time, made it possible for the US economy grow, in a way that benefited consumers during the last decade of the 20th century.

The good old Greenspan days

Indeed, during most of the 1990s and during Mr Greenspan's term in the Fed, as more and more Americans invested their savings and pension plans in the stock market, many policy makers and the general public seemed to accept it as a given that what was good for Wall, was good for Main Street.

Coming to the aid of America's investors in their time of trouble is, by definition, a way to assure the strength of the US economy.

But in the aftermath of the news about the sub-prime mortgage mess and the growing credit crunch, there is rising tendency to challenge this conventional wisdom. It is now argued that Mr Greenspan's policy that ensured that investors would not fail because of inadequate financing may have created unnecessary expectations that the Fed would always be there to protect investors. As a result, his policy may have encouraged them to take major risks that may have helped produce the current financial crisis which is now hurting not only the wealthy hedge fund players but also members of the middle class that have spent recent years refinancing their mortgages and over-maxing on their credit cards as they all went on a huge spending spree.

Hence, the concern among economic observers that by trying to 'do a Greenspan' by sending a signal to Wall Street that, not to worry, the Fed is coming to the rescue and is ready to supply you guys with cash, Mr Bernanke could make a messy situation worse.

From that perspective, the earlier decision by the Fed to only lower the discount rate and ease lending terms - and refrain from cutting the federal funds rate a la Greenspan was seen as exactly the kind of medicine that was required.

Reading the tea leaves

But the problem was that, that move in itself also created the expectation that the Fed would have no choice but to cut the federal funds rate in its next meeting of the Federal Open Market Committee, the Fed's policy-making body, on Sept 18.

Not surprisingly, Wall Street and other Fed watchers were hoping that by deconstructing Mr Bernanke's speech on Friday, they would be able to gain more of an insight into the next Fed move. And again, the dilemma faced by Mr Bernanke was that his comments and the signals he would be sending would have an effect on the behaviour of the market and force him eventually to take steps, like cutting interest rates, that may not be required based on the current limited crisis in the financial markets and the conditions of the economy.

In a way, what Mr Bernanke did on Friday was to help maintain the same level of uncertainty in the financial markets that had existed before he made his address. Even the most skilful 'deconstructionist' who listened to or read the Fed chairman's speech, a mix of comforting statements aimed at calming the financial markets and frosty rhetoric that seemed to reject the notion of bailing out irresponsible behaviour, could not have figured out what exactly Mr Bernanke and his colleagues are going to do on Sept 18.

It is quite possible that they themselves are now sure which direction they would be taking in the coming days.

Mr Bernanke told his global audience that the Fed would continue to monitor the developments in the financial markets and would stand ready 'to take additional actions as needed to provide liquidity and promote the orderly functioning of markets', which sounded quite calming.

But then he stressed that 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', which sounded quite frosty.

And yet, he pointed out that 'developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy', which again sounded somewhat calming.

These mixed messages and the nuanced tone of Mr Bernanke's address helped explain why it ended up as a Rorschach test of sorts for market watchers who interpreted it based on what they were hoping to see in it.

Those investors who believe that Mr Bernanke and his colleagues were serious about a rate cut to deal with the recent credit and stock market volatility insisted that they weren't disappointed by the speech (which explains why the headlines in some business newspapers indicated that the Fed chairman 'hinted' that he was planning to cut rates).

At the same time, those market watchers who are confident that the Fed was not going to 'do a Greenspan' and would be taking less drastic steps than his predecessor to deal with the market instability were reassured that the Fed was not going to cut rates in its next meeting (as some newspaper headlines speculated).

Comments by President George W Bush on Friday that the government would help some homeowners trying to make their mortgage payments but would not bail out the greedy lenders, also contributed to the sense that Washington would be focusing most of its attention on dealing with the economy and would not rush to the aid of investors.

'The government's got a role to play, but it is limited,' Mr Bush said at the White House. 'A federal bailout of lenders would only encourage a recurrence of the problem.'

But since the conditions in the financial markets do have a huge impact on the general economy, Mr Bush, like Mr Bernanke, refrained from closing the door on the possibility under certain conditions to 'act as needed' to assist the economy, which is the formula Mr Bernanke used in a letter to Democratic Senator Charles Schumer that was released last week. Stay tuned.