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A Tougher Tone at the Top
Bernanke Answers Critics With Assertiveness

By Neil Irwin
Washington Post Staff Writer
Saturday, January 19, 2008

When Ben S. Bernanke became Federal Reserve chairman two years ago, he set out to be the man in the gray flannel suit -- more anonymous bureaucrat than swashbuckling master of the economy.

Now Bernanke is discovering that, in times of crisis, the world wants a swashbuckler.

After months of criticism from people on Wall Street who argue that Bernanke has responded timidly to the crisis in the housing and credit markets, he has taken a more assertive approach. Last week, he gave a speech that used bold language to signal that the Fed would cut interest rates to try to prevent a severe economic downturn. On Thursday, he told Congress how to design a stimulus package that would offer immediate help.

The two moves are meant to assure financial markets, elected officials and the American public that the Fed is on the case.

"The financial markets and the whole society are crying out for leadership," said Alan S. Blinder, a Princeton economist and former Fed vice chairman. "Bernanke as a person and the Fed as an institution are the places this leadership can come from."

It is all but inevitable, in the view of Fed leaders, that the economy will grow slowly in the first half of 2008. There may even be a mild recession, they say. But Bernanke is trying to indicate that he and his colleagues at the central bank will not let a painful, self-reinforcing cycle set in that could cause a severe and prolonged downturn.

In this highly negative scenario, lower home prices cause foreclosures, which cause more losses in the financial sector, resulting in less credit available to consumers and businesses, leading to still lower home prices.

"By cutting interest rates to offset the negative effects of financial turmoil on aggregate economic activity, monetary policy can reduce the likelihood that a financial disruption might set off an adverse feedback loop," Frederic S. Mishkin, a Fed governor, said in a recent speech. Mishkin's thinking is generally close to that of Bernanke.

The Fed is taking a page from the playbook of Alan Greenspan, Bernanke's predecessor. By cutting interest rates aggressively at the end of January and beyond, as is likely, the Fed would be an example of "risk-management" strategy -- trying to prevent a situation that, however unlikely, would be disastrous.

Part of that negative cycle the Fed fears is psychological: Fear of rapidly dropping home prices and further financial crisis makes it more likely to happen. That's where the tough talk from Bernanke comes in.

One of the idiosyncrasies of being a central banker is that words can matter as much as policy. If, because of his recent speeches, people believe a severe recession is less likely, then they will be more willing to spend and invest.

In that sense, Bernanke's recent behavior is at odds with his stated desire to reduce his presence in the spotlight. "Bernanke did want to be more anonymous and behind-the-scenes kind of person," said Dean Croushore, a University of Richmond economist who wrote a textbook with Bernanke. "But in a crisis, that's when people have to step up to the plate, and that's what he's doing."

Bernanke will not routinely tip his hand as to what the Fed plans to do as clearly as he did in his speech Jan. 10. Then, he said: "We stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks."

He was able to so explicitly signal the Federal Open Market Committee's intentions in that speech because economic data had deteriorated so obviously in late December and early January that there was wide consensus on the committee about what direction its policy should take.

The assertive tone also helped deal with a problem that has nagged the Fed throughout the financial crisis since it began in August: criticism from people in financial markets that the central bank has sent mixed signals about its plans.

There are five Fed governors and 12 presidents of regional banks, all with different views of the economy. In November, for example, as financial markets were experiencing another wave of seize-ups, Randall Kroszner, a Fed governor, and Charles Evans, president of the Chicago Fed, gave speeches that warned of the risk of inflation, suggesting the central bank was not inclined to cut rates again. The Fed cut rates at its next meeting.

"Bernanke's style is to say, 'Let's throw everything out on the table and have more of an academic type of debate,' " Croushore said. "When you do that, the Fed doesn't speak with one voice continuously. That's very healthy when times are normal. But once you hit a crisis phase, that's when I think the dissenting voices have to be a little quieter."

Communications are not the only challenge for Bernanke. The aggressive interest rate cuts he has signaled could spur inflation, by increasing Americans' expectations for future price increases.

Rising prices can be a self-fulfilling prophecy, as they were in the 1970s; if people expect prices to rise, they budget the increases, which results in inflation.

"Bernanke's rhetoric has completely changed from a balanced concern about unemployment and inflation to a complete neglect of the inflationary consequences of what he's doing," said Allan Meltzer, a Carnegie Mellon economist and a noted historian of the Federal Reserve.

"He is a very able academic, and he's thrown all that away and is repeating the mistakes of the 1970s," Meltzer said in a telephone interview yesterday. "A country that can't accept the possibility of a modest recession is going to have inflation, and then will eventually end up with a much bigger recession."

Many other economists think such an inflationary spiral is unlikely because a slowing economy would mean less upward pressure on prices, and few forecasts call for energy prices to keep rising this year at the rate they have in the past.

In congressional testimony Thursday, Bernanke said: "Any tendency of inflation expectations to become unmoored or for the Fed's inflation-fighting credibility to be eroded could greatly complicate the task of sustaining price stability" and make it hard to combat a slowing economy. He said he will be closely monitoring inflation expectations.

Meltzer is not persuaded. "Bernanke is much more political now," he said. "I think he's responding to the pressures that come from day traders on Wall Street, the Congress, which faces an election, and the administration, which faces an election. Those are exactly the things he should be trying to ignore."

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