By Nell Henderson
Washington Post Staff Writer
Saturday, November 12, 2005
Wall Street was growing worried in November 2002 that the Federal Reserve might not be able to keep the economy from tumbling into another downturn.
Economic growth was sluggish, just a year after a recession and terrorist attacks. And inflation was falling unusually low, even though the Fed's benchmark short-term interest rate was at its lowest level in more than four decades. The Fed couldn't lower the rate much more, and soon might have no power to spur a more vibrant expansion, many analysts speculated.
Wrong, said Ben S. Bernanke, a former Princeton economics professor who had joined the Fed board just four months earlier.
Bernanke, in a speech, reassured the markets that the Fed still had several weapons to stimulate the economy and had "most definitely not run out of ammunition." Bernanke also suggested that the Fed had beaten inflation, its arch-enemy since the 1970s, and had shifted its focus to a new danger -- deflation, the crippling decline in overall prices that plagued the United States during the 1930s and Japan in the 1990s.
To listeners in financial markets, Bernanke's words marked a turning point for the Fed and heralded the arrival at the central bank of a new voice and strategist to help guide the economy through a dicey time.
"It was a powerful speech that was nothing less than a declaration of victory against inflation, a regime shift" for the Fed, recalled Paul McCulley, managing director of Pimco, or Pacific Investment Management Co. "We recognized that was a profound moment in monetary policy."
Now, just three years later, Bernanke appears headed toward easy Senate confirmation as President Bush's nominee to succeed Alan Greenspan as Fed chairman. However, some skeptics question whether the one-time academic is prepared to work with financial markets and translate theory into effective policy. Bernanke is not giving public interviews during the confirmation process, but several money managers and analysts say his experience at the Fed should allay such concerns.
Bernanke's performance as a Fed board member from August 2002 through earlier this year "proved he was not just a man of books, he was a man of action," McCulley said.
Bernanke joined the Fed after an academic career that established him as a leading expert on monetary policy -- the central bank's efforts to keep inflation and unemployment low by controlling the growth of the money supply, primarily through adjusting interest rates.
The Fed's economists quickly appreciated his expertise and eagerness to work with them, according to current and former Fed colleagues.
"The staff love him. They're turning cartwheels" at the thought of Bernanke becoming chairman, said Edward M. Gramlich, who left the Fed board in August after serving for eight years. Gramlich and others who worked with Bernanke at the Fed describe him then as thoughtful, substantive, direct and quietly persuasive.
"Ben is an easy guy to like," said Robert D. McTeer Jr., the former president of the Federal Reserve Bank of Dallas. Bernanke tended to promote his ideas through speeches or articles, and "didn't engage in any hard-sell in the [Fed policymaking] meetings," McTeer recalled. "It was all very gentlemanly."
By Bernanke's third Fed policymaking meeting, in November 2002, the central bank's top officials agreed to cut the benchmark rate to 1.25 percent to boost an anemic economy. Some of the policymakers worried about the possibilities of war in Iraq, another terrorist attack or some other shock that might hurt the economy and trigger deflation.
Low interest rates normally stimulate the economy by encouraging consumers and businesses to borrow and spend. But at that time, some private economists were asking what more the Fed could do if it lowered its benchmark rate to zero and the economy continued to slump.
Greenspan replied in remarks to Congress that the central bank could influence more than the benchmark federal funds rate, the rate charged between banks on overnight loans. The Fed also could lower longer term rates, such as those on mortgages and bank loans, by buying Treasury securities of various maturities, up to 30-year bonds, he said.
Bernanke elaborated on this point in his speech a week later, saying the Fed had many options for stimulating economic growth and combating deflation, including buying Treasuries, lending to banks or driving down the value of the dollar.
"The U.S. government has a technology, called a printing press (or today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost," Bernanke said. "Under a paper-money system, a determined government can always generate higher spending and hence positive inflation."
The other key idea Bernanke floated then was to use public communication -- in short, words -- to hold down long rates.
Long-term interest rates are based in part on what financial markets expect the Fed will do in the future. If the Fed publicly committed to holding down its benchmark rate for some period, that should keep long rates low as well, Bernanke argued.
"It was reassuring to know the Fed had a plan for dealing with an economy that might be moving into a deflationary period," recalled William Fitzgerald, managing director at Nuveen Investments Inc., an investment management company. "There was tremendous uncertainty in the markets over what it would mean."
Greenspan, Bernanke and other Fed officials addressed the topic over the following months, emphasizing that deflation was unlikely, but possible. By June 2003, however, many traders had bought bonds in expectation that the Fed would cut its rate below 1 percent and buy long-term Treasuries.
Those speculators lost a lot of money that summer when the Fed did neither of those things. Instead, Fed officials lowered the benchmark rate to 1 percent in June, and both Greenspan and Bernanke said in speeches that the Fed would probably hold the rate low for a "considerable period." Words had become the Fed's chosen tool, as Bernanke had suggested.
"In a world in which inflation risks are no longer one-sided and short-term nominal interest rates are at historical lows, the success of monetary policy depends more on how well the central bank communicates its plans and objectives than on any other single factor," Bernanke said in July.
The Fed has foreshadowed its future actions in the statement issued after every policymaking meeting since. In August, 2003, for example, the Fed said it would likely hold the funds rate low for "a considerable period," and repeated that phrase after several more meetings. For more than a year, the committee has said it is likely to raise the funds rate at a "measured" pace, or in small, gradual steps.
Some Fed officials want to scrap any phrase about future actions, arguing that it might limit their options. But Bernanke has argued in various speeches that that the predictive language worked. It helped hold down long-term rates as the economy gained steam in late 2003 and early 2004, he has said.
In his first predictive words after Bush tapped him for Fed chair, Bernanke promised to "maintain continuity" with Greenspan's policies. But he also said the Fed "will continue to evolve in the future."