Bernanke's Inflation Concerns Intensify
Fed's Geithner Calls for Stronger Financial Oversight

By Neil Irwin
Washington Post Staff Writer
Tuesday, June 10, 2008

CHATHAM, Mass., June 9 -- Federal Reserve Chairman Ben S. Bernanke signaled deepening concern over inflation last night and said that the central bank will "strongly resist" any tendency for Americans' expectations of price increases to become unhinged.

Earlier in the day, New York Federal Reserve President Timothy F. Geithner called for stronger regulation of financial institutions, in the central bank's most extensive effort yet to propose changes that might prevent future financial crises like that of the past 10 months.

Their remarks reflect the challenges the Fed is facing as the economy and the financial system continue to struggle and the activist role the central bank is playing on multiple fronts.

Bernanke's comments were a response to events on Friday, when the price of oil and the nation's unemployment rate both soared. Using more forceful language about inflation than he did in a speech just a week earlier, Bernanke made clear that higher energy costs worried him most.

"The latest round of increases in energy prices has added to the upside risks to inflation and expectations," Bernanke said in a speech at a conference of the Boston Fed last night. Fed policymakers "will strongly resist an erosion of longer-term inflation expectations."

Those words do not mean the central bank will increase interest rates anytime soon. The Fed is likely to leave the short-term rate it controls unchanged when it meets late this month.

However, the language does suggest that Bernanke is more open to rate increases later this year, particularly if there are signs that higher prices for fuel are spreading to a broader range of goods.

Bernanke also addressed the higher jobless rate -- unemployment rose to 5.5 percent in May from 5 percent in April, the government said Friday. But he suggested that worsening economic conditions are roughly in line with what he was expecting as the Fed cut interest rates through the spring, and that the risk of a deep downturn has diminished.

"Despite the unwelcome rise in the unemployment rate that was reported last week," Bernanke said, "the recent incoming data, taken as a whole, have affected the outlook for economic activity and employment only modestly."

The Fed is charged by Congress with a "dual mandate" of trying to ensure low unemployment and price stability. For most of this year, the Fed has viewed slow growth as the foremost risk it was facing. Last night's speech -- coupled with comments from Bernanke last week expressing worry about the falling value of the dollar -- signaled that that balance of risks is shifting toward inflation.

Geithner, a key engineer of the Fed's response to the crisis, including the rescue of investment bank Bear Stearns in March, focused yesterday on the Fed's role in bringing balance to the financial system. Speaking before the Economic Club of New York, he proposed steps that might make the system less prone to disastrous breakdowns like those that transpired this year.

For example, he said that large financial institutions need to be required to hold more capital when times are good, to prevent them from facing a run on the bank when things are bad.

"Inducing institutions to hold stronger cushions of capital and liquidity in periods of calm may be the best way to reduce the amplitude of financial shocks on the way up," Geithner said, "and to contain the damage on the way down."

He said that big financial firms need to push harder to bring order to the Wild West-style markets for derivatives, sophisticated financial investments for which products trade irregularly, often privately, and with few guarantees that the other party can fulfill their financial obligations under a trade.

One of the major reasons the Fed leaders backed the emergency acquisition of Bear Stearns was that they feared that if it been allowed to dissolve overnight, it would have created chaos in derivative markets.

Geithner, echoing an elaborate proposal by Treasury Secretary Henry M. Paulson Jr., said the nation's fragmented system for regulating banks and other financial institutions needs to be consolidated -- and in Geithner's vision, the Fed would take on new power. Currently the Fed can order commercial banks to adjust their exposures to a given type of asset or to improve their systems for measuring risk -- but has no such formal power for investment banks and a range of other financial institutions.

"At present the Federal Reserve has broad responsibility for financial stability not matched by direct authority," Geithner said, "and the consequences of the actions we have taken in this crisis make it more important that we close that gap."

He stopped short of proposing new regulation of hedge funds or private-equity firms.

Geithner said that fundamentally too much regulation of big financial firms is oriented toward making sure they can remain solvent -- not on making sure the financial system as a whole keeps functioning.

"Risk management and oversight now focuses too much on the idiosyncratic risk that affects an individual firm and too little on the systematic issues that could affect market liquidity as a whole," Geithner said.