One and done. That's what some commentators are saying about the decision of the Federal Reserve Board's monetary policy committee to cut the Fed funds rate by 50 basis points (half of a percentage point), twice what the market had been expecting. They reason that chairman Ben Bernanke had a choice between too much, too soon, and too little, too late--and chose the former. Both choices are not without risks. Cut rates and he might unleash inflation by stimulating an economy that is already growing at a reasonable pace. And he might create that bane of all central bankers, moral hazard, by bailing out improvident lenders and borrowers, emboldening them to repeat past errors, confident that the Fed will save their bacon every time.
But too little, too late also carried risks. Financial markets are, to put it mildly, nervous. Credit is not easy to come by; panicked depositors lined up last week in Britain to demand their money back from branches of Northern Rock; some mortgage-related institutions are already in or on the brink of bankruptcy; and next year's resetting of teasingly low initial mortgage rates threatens tens of thousands of homeowners with foreclosure. "The turbulence originated in concerns about subprime mortgages, but the resulting global financial losses have far exceeded even the most pessimistic estimates of the credit losses on these loans," Bernanke told Congress two days after reducing the Fed funds rate from 5.25 to 4.75 percent. Better to be a bit too generous, even with the attendant risks, if that's what it takes to forestall a possible cataclysm in financial markets. So holds Bernanke.
But the "one and done" crowd, which thinks Bernanke has headed off inflation by hinting he will not cut rates further, might be mistaken. First, Bernanke may not be done. If economic conditions deteriorate, last week's cut could be the first of several: Some forecasters think the Fed funds rate will fall to 4.0 percent by the first quarter of 2008, and to 3.5 percent by this time next year.
Second, it is not clear that the economy is so soft that it can absorb this stimulus without an increase in inflation. New data suggest that the jobs market is stronger than the earlier jobs reports led us to believe. Earnings remain relatively good, even at the troubled investment banks--Goldman Sachs stunned analysts by reporting robust revenues and profits for the last quarter. Retail sales are not what shopkeepers would like (are they ever?), but back-to-school and luxury goods have moved smartly off the shelves. Exports are rising at an annual rate of about 15 percent. Oil and other commodity prices are rising, as are labor costs.
All of this has added to fears that Bernanke, who once joked that the way to end a recession is to drop money from helicopters, has won instant popularity at the price of future inflation. No less an authority than Alan Greenspan, while careful to say that he "would be hard-pressed to see what I would have done differently," warns that because productivity is not likely to increase very rapidly, and the price-dampening effect of globalization has played itself out in part, inflationary pressures are on the rise.
The markets are indeed worried. The dollar's drop is accelerating so rapidly that it has fallen to par with the traditionally forlorn Canadian dollar for the first time since the 1970s. Long-term interest rates are up, as investors fear that the value of their investments will be eroded by inflation. That's the verdict of the bond market, the institution that Clinton adviser James Carville held in such awe that he famously cried, "When I come back I want to come back as the bond market, because then you can intimidate everybody." Not Bernanke, who remains calm in the face of rising long-term interest rates. The inflation genie might still be bottled up, but the Fed chairman has fearlessly loosened the cap.
No matter. Applause for Bernanke reverberates in the halls of Congress, the boardrooms of America, and on the floors of the world's exchanges. "The Fed chairman has demonstrated very important economic leadership," Jim O'Neill, Goldman Sachs's head of global economic research, told the firm's clients last week.
So far, Bernanke's luck has held. Shortly after he cut rates, the government reported that consumer prices fell in August: so much for inflation fears. Housing starts dropped to 42 percent below their January 2006 peak, a 12-year low, and the National Retail Federation is predicting a less than jolly Christmas selling season: so much for fears of an overheating economy.
Most important to Bernanke's new legion of fans, stock prices have rebounded, and credit markets are beginning to function more normally. Corporate borrowers suddenly find capital markets open to them. Lehman Brothers Holdings and General Electric immediately issued bonds, and R.H. Donnelley sold more than $1 billion in junk bonds, the first such sale since the credit crunch hit in the summer. Deal-makers emerged from their funk as the prospects for financing the backlog of transactions improved, although on terms less favorable than in the good old pre-credit-crunch days. After "a quiet period in new transactions through the first quarter of 2008," Goldman Sachs's head of merchant banking, Rich Friedman, is advising his clients, deals will pick up, but they will be smaller and less wildly remunerative.
Lessons have been, or should have been, learned:
* Bernanke might have created some moral hazard by seeming to bail out financial institutions that behaved badly, but lenders are unlikely to throw money at the penurious homeless or firms dependent on that group. Bankers have famously short memories, though, so some review of institutional regulation is probably in order.
* Pragmatic activism trumps academic dithering. Ben Bernanke's hero status contrasts sharply with that of Mervyn King, governor of the Bank of England. He admirably held to his anti-moral-hazard, hands-off policy. Panic ensued, and the British government was forced to stem a bank run by guaranteeing bank deposits. Talk now centers on when, not whether, King will be forced to resign. The contrast between Bernanke's popularity and King's likely fate will not be lost on central bankers.
* Ideology is a poor guide to policy during periods of financial difficulty. The Bush administration resisted efforts to expand significantly the ability of various agencies to ease conditions in mortgage markets, but has had to beat a partial retreat in the face of criticism from Democrats in Congress.
* Most financial institutions in America are in good shape, with strong balance sheets. The recent period of illiquidity had its impact, to be sure, but no major bank was threatened with destruction.
When all is said and done, we are once again reminded of the wisdom of Walter Bagehot, who noted during the monetary crisis of 1857 that "panics will occur every now and then. . . . In America . . . we cannot reasonably anticipate anything but an occasional repetition." Bernanke has no reason to fear boredom once the current crisis has passed.
Irwin M. Stelzer is a contributing editor to THE WEEKLY STANDARD , director of economic policy studies at the Hudson Institute, and a columnist for the Sunday Times (London).