As economy slows and Fed voices conflict, markets look to Bernanke for guidance

Now that President Obama has signed his financial overhaul bill into law, here's a look at who in Washington has played an important role in deciding its fate.
By Neil Irwin
Washington Post Staff Writer
Wednesday, August 25, 2010; 11:02 PM

With the housing market retreating, unemployment lingering and top officials at the Federal Reserve in open disagreement over what to do, Fed Chairman Ben S. Bernanke is under rising pressure to offer solutions in an address Friday that is likely to be his most important since the end of the financial crisis.

The central bank's policy intentions have been unusually muddled in the past two months, according to a widespread view among economists and people in the financial world. They say it is unclear how likely it is that the Fed will undertake major new efforts to try to support the economy, what economic conditions would trigger such actions and what form those actions would take.

Meanwhile, evidence mounts that the economic recovery is coming unglued. On Wednesday, the Commerce Department reported that sales of new homes in July hit an all-time low. Orders for durable goods, the kind of big-ticket spending that had been fueling economic growth, rose a bare fraction of what experts had predicted.

With statistics due out Friday that are expected to show the economy grew much less than estimated in the second quarter of the year, Fed-watchers are hoping Bernanke's comments later that day in Jackson Hole, Wyo., will instill confidence that he has a plan and can act decisively if the economy continues to deteriorate. They warn that recent conflicting signals from Fed insiders may even be contributing to economic weakness by spooking financial markets.

Some of the most vocal Fed policymakers have expressed diametrically opposite views on the economic outlook and their preferred course for policy, and Bernanke and his closest collaborators have been quiet in recent weeks.

"The chatter you're getting around policy right now is such a cacophony," said Ethan Harris, head of North American economics research at Bank of America-Merrill Lynch. "There's just a bunch of wildly different views being presented from both inside and outside of the Fed, and that is confusing markets."

The sense of confusion reflects the downside of Bernanke's leadership style. Bernanke is comfortable with other policymakers openly disagreeing with him and has led a more collaborative, consensus-driven Fed than his predecessor, Alan Greenspan. That approach paid dividends during the financial crisis.

Bernanke guided a complicated policy apparatus - which when fully staffed includes seven Washington-based governors and the presidents of 12 regional Fed banks across the country - to take aggressive, unconventional steps to combat the recession.

Policymakers with disparate views felt that their opinions were given serious consideration and thus were willing to follow the leader on unconventional policies, even when they had reservations.

But now, facing not an imminent financial collapse but a slow-moving problem of economic growth that is too slow to bring down joblessness, the costs of that management style are on display. In the past month, for example, Federal Reserve Bank of St. Louis President James Bullard published a paper asserting that the U.S. economy is at risk of a protracted period of falling prices and economic weakness known as deflation. The central bank should consider pumping hundreds of billions of dollars into the economy to preempt that risk, he argued. Bullard also appeared on CNBC to discuss that view at length.

Kansas City Fed President Thomas Hoenig has given speeches and interviews arguing the opposite problem. He sees the recovery as solid and has argued that the Fed's interest rate target should be increased so as to avoid stoking asset bubbles or inflation.

Neither man's arguments are within the mainstream of opinion on the Fed policy committee, where the majority view holds continued expansion as likely, deflation unlikely and rock-bottom interest rates to be justified for quite a while to come. But they and a handful of others, including Philadelphia Fed President Charles Plosser and Dallas Fed President Richard Fisher, have been more visible publicly than those who are closer to the center.

And since the Fed decided Aug. 10 to take the modest step of buying more assets to replace those on its balance sheet that mature, neither Bernanke nor those who are closest to him - such as New York Fed President William C. Dudley and governors Donald L. Kohn and Kevin M. Warsh - have made a public appearance to explain the rationale for the move or indicate the likelihood of more aggressive steps to support growth.

Instead, market participants have heard from Minneapolis Fed President Narayana Kocherlakota, the newest policymaker on the committee, who said the Fed's decision "had a larger impact on financial markets than I would have anticipated."

Rather than criticize or call out colleagues for bringing the Fed's internal debates into the public sphere, Bernanke has subtly encouraged this airing of opinions, praising points that some of his colleagues have made in Federal Open Market Committee meetings or private e-mails.

But the question now is whether he can corral people with disparate views into making a coherent monetary policy.

"It's Bernanke's leadership style, and it has been since Day One, to encourage transparency and open debate," said Diane Swonk, chief economist at Mesirow Financial. "That's a good thing in general, but right now, while we're not sure where policy is going, it brings confusion to financial markets rather than clarity."

Part of the challenge Bernanke faces in his speech Friday, to be delivered at the Kansas City Fed's annual economic symposium taking place at Grand Teton National Park, is to reassert leadership even as he cannot be too precise about the course of Fed policy, Fed watchers said.

Fed leaders view the slowing pace of recovery as disturbing, but hold to the view that continued expansion is more likely than a dip back into recession. If economic growth slows significantly, the Fed would consider large new purchases of Treasury bonds and mortgage-backed securities, to the tune of hundreds of billions of dollars, a strategy that is known as quantitative easing.

But it is an open question how much impact such a move would have on growth, given that interest rates are already very low. Several members of the Fed policymaking committee, including Hoenig and Plosser, are likely to be strongly opposed to any such move.

People involved in financial markets will read Bernanke's speech closely for evidence of what the Fed's "reaction function" is. In other words, how much worse would the economy have to get before a new bond purchase program was undertaken?

More than anything, they will be looking for signs that there is a plan and that the Fed can move decisively if necessary.

"He needs to overcome this idea that the Fed is paralyzed, either because they don't have the tools to succeed or because they don't all agree," said Ethan Harris, the Bank of America-Merrill Lynch economist.

"He will need to admit the recent weakness in the data, justify the action they took at the last meeting, yet not be alarmist and sound desperate. That balancing act will be tough."

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