The Fed: Balancing Economic and Financial Concerns
By Jules Stuart Pierre, Ph.D., CFA(1)
August, 10th 2007
Fed Chairman Ben Bernanke
On Tuesday, August 7th 2007, Wall Street and other world financial centers were waiting impatiently the results of the meeting of the Federal Reserve Bank, commonly known as Fed, on the conduct of monetary policy and the necessary interventions in the bond market. Held by a Fed committee named Federal Open Market Committee (FOMC) that usually meets eight times a year, the August 7th meeting took place in an uncertain financial environment, due to the financing difficulties faced by sub-prime borrowers and high yield companies.
Having a mission with a dual mandate, to fight inflation and to promote growth, the Fed has flexibility in conducting monetary policy. Moreover, the style of the acting chairman becomes an important factor in policy decisions. When Ben Bernanke became fed chairman in February 2006 some analysts thought he would follow the path of his predecessor Alan Greenspan. Greenspan, who chaired the fed during the longest boom of the American economy after the second world-war, implicitly gives priority to financial stability relative to the fight against inflation. On several occasions he adopted an easy monetary policy in order to calm financial markets.
That was the case, not only in October 1987, after “black Monday”, but also in 1998, in order to avoid a contagion from the emerging markets crisis, and in January 2001, less than two months after having announced that his main concern was inflation. All those interventions were based on the following logic: when there are problems that may cause a credit crunch it is necessary to supply liquidity to the financial system in order to maintain growth.
Used to Greenspan’s approach, Wall Street was expecting, if not an immediate decrease of the targeted fed-fund rate (the cost of borrowing reserve in the inter-bank market), at least a change in the stance of monetary policy signaling a decrease in the fed-fund rate at the September meeting.
The CFO of Bear Stearns Co. declared on Friday, August 3, 2007 that “the fixed-income market is in the worst shape in 22 years”(2). Until Monday, August 6, 2007, Wall Street traders placed odds of a rate cut in September at 70%(3).
On Tuesday, August 7, 2007, the FOMC decided unanimously to maintain its target interest rate, the fed-fund rate, at 5.25%. More surprising, no definite indication was given on a change of the stance of monetary policy in the near future from tightening to easing.
The Fed certainly recognized the poor performance of portfolios containing sub-prime mortgages. At least 70 mortgage firms either have halted operations, gone bankrupt or sought buyers since the start of 2006(4).
As long as those problems are limited to a few institutions, which is not a threat to the stability of the financial system, the fed doesn’t want to change its monetary policy. Following the 3.4% rate experienced in the second quarter(5), the Fed expects the economy "to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and income, and a robust global economy"(6).
The Fed acknowledged that its growth prediction is uncertain. Indeed, consumption spending grew at an annual rate of 1.3% in the second quarter of this year, the lowest rate since the end of 2005(7). However, the fed said in its FOMC statement that their "predominant policy concern remains the risk that inflation will fail to moderate as expected".
It’s only last June that the core of the price index of personal consumption spending decreased from 2% to 1.9%, falling inside the 1% to 2% comfort range of the Fed.
On Wednesday, August 8, 2007, some analysts were optimistic because they interpreted the fed’s explicit acknowledgement of the recent financial market volatility and deteriorating credit conditions as evidence of a step to a neutral stance.
Other analysts noted that instead of focusing on the expected change in the stance of monetary policy, the market should take account of a change of approach that probably marks the end of the Greenspan era.
Indeed, it seems that Bernanke wanted to acquire a reputation for toughness, and wanted to signal that he would change his position about the principal risk to avoid, from inflation to recession, not based on bond market conditions, but based on the state of the real economy. However, after the 2.8% fall experienced on Thursday, August 9, 2007 by the most important stock market index, the Dow Jones Industrial Average, that was caused by the sub-prime debacle, the Fed decided to inject $38 billion of liquidity in the financial system and pledged to supply more as necessary(8).
In the upcoming weeks, Mr. Bernanke’s challenge would be to stabilize financial markets while keeping expectations about inflation in check.
Contact: jpierre99 @ hotmail.comNotes
(1) Currently an Adjunct Professor of Finance & Economics at Florida Atlantic University, Jules Stuart Pierre, holds a doctorate in Economics from Fordham University, with specialization in International Economics and Finance. He holds the CFA designation, awarded by the Chartered Financial Analyst Institute.
(2) Bernanke Looks Beyond Market to Focus on Inflation. By Craig Torres. 08/08/07
Bloomberg.com
(3) Market Gyrate as Fed Straddles Inflation, Growth. By Greg Ip. 08/08/07
The Wall Street Journal
(4) Bernanke Looks Beyond Market to Focus on Inflation. By Craig Torres. 08/08/07
Bloomberg.com
(5) Market Fears Must Not Drive the Fed. Editorial. 08/07/07
Financial Times
(6) FOMC Statement – Press Release. 08/07/07
Federal Reserve Release
(7) Not Putting Out. 08/08/07
Economist.com
(8) Central Banks Add Cash to Avert Crisis of Confidence. By Lanman & Vits 08/08/07
Bloomberg.com
