-- Federal Reserve policy makers, who declared that inflation was their paramount challenge just two weeks ago, have been forced to make financial-market stability the trigger for changes in interest rates.
By lowering the discount rate and issuing a statement conceding threats to the economy, Federal Open Market Committee members effectively ripped up the economic-outlook statement from their Aug. 7 meeting. Some economists describe the about- face, coming after months of assurances that the subprime- mortgage rout was contained, as Chairman Ben S. Bernanke's first serious error since taking office last year.
``It was a rookie mistake,'' said Kenneth Thomas, a lecturer in finance at the University of Pennsylvania's Wharton School in Philadelphia. The Fed ``underestimated liquidity needs'' of investors and the fallout from the housing recession, he said, adding, ``This demonstrates the difference between book-smart and street-smart.''
Bernanke, a former chairman of the economics department at Princeton University, has elevated the role of forecasts in Fed policy rather than amassing clues from dozens of market indicators as predecessor Alan Greenspan did. The Fed forecasts showed that ``moderate'' growth would continue, and that inflation remained the biggest danger. The credit collapse has undermined that stance, and Bernanke may cut the benchmark interest rate by at least a quarter-point at or before the Sept. 18 FOMC meeting, analysts say.
Tough to Model
``Sometimes, the dynamics change very, very quickly,'' said former Fed governor Laurence Meyer, who voted for the three reductions in 1998 after currencies in Asia, Russia and Latin America tumbled. Bernanke's shift ``tells us how difficult it is to translate financial turbulence into the macroeconomic forecast.''
The Fed on Aug. 17 lowered its discount rate -- what it charges banks for direct loans -- by 0.5 percentage point to 5.75 percent, in an effort to increase liquidity in longer-term loans and bonds.
The initial request for the move came from Fed district banks in New York and San Francisco. They are led respectively by Timothy Geithner and Janet Yellen, both former Clinton administration officials who dealt with the 1997-1998 currency crises. The Fed's Board of Governors in Washington is dominated by academics.
Meyer's Call
Meyer, vice chairman of Macroeconomic Advisors LLC in Washington, recommended prior to the Aug. 7 FOMC meeting that policy makers cease describing inflation as the biggest risk. By saying the risks to growth and inflation were roughly equal, the central bank would have given itself room to maneuver if markets -- already weakening -- continued to slide.
The committee said in its statement three days ago that ``the downside risks to growth have increased appreciably'' because of the tumult in markets. Officials abandoned the prediction of a ``moderate'' expansion, and inflation wasn't mentioned.
While leaving the main rate at 5.25 percent, the panel said it is ``prepared to act as needed to mitigate the adverse effects on the economy.''
Stocks rallied after the announcement, but credit markets remained unsettled. The Standard & Poor's 500 Index climbed 2.5 percent, the biggest rally in four years. By contrast, asset backed commercial paper yields jumped the most since the Sept. 11, 2001, terrorist attacks. Top-rated paper maturing Aug. 20 yielded 5.99 percent late on Aug. 17, up 39 basis points in a day. A basis point is 0.01 percentage point.
The S&P 500 was little changed today, down 0.1 percent.
`Bleeding Into the Economy'
``The Fed has an easing bias, but it is not an easing bias dictated strictly by economic conditions,'' said Stephen Stanley, chief economist at RBS Greenwich Capital Markets in Greenwich, Connecticut. ``This is a financial-market issue, which is then bleeding into the economy.''
Last week's policy shift notwithstanding, Bernanke's moves to resolve the credit crunch so far have been restrained. Even then, and unlike the Greenspan era, it was the Fed doing the talking, not any one individual.
The Fed pumped $38 billion into the banking system on Aug. 10 to free up financing in short-term credit markets, and issued a six-line statement. The injection was the Fed's biggest since the meltdown began. By contrast, the European Central Bank added $130 billion in temporary reserves a day earlier. ECB President Jean-Claude Trichet followed up with media interviews designed to reassure investors.
The Bernanke Fed
``We're getting a nice further look at the new Bernanke Fed,'' said Ethan Harris, chief U.S. economist at Lehman Brothers Holdings Inc. in New York. ``He definitely wants to use the committee and these more formal directives,'' as opposed to Greenspan's preference for speeches laden with ``code words.''
The reduction in the discount rate, which is used less than the federal funds rate as a policy-making tool, wasn't directed at the broad economy so much as at trying to ease gridlock in credit markets. The Fed said it would accept everything from home-equity loans to municipal bonds as collateral for discount- window loans up to 30 days.
The decision to keep the benchmark overnight lending rate unchanged -- for now -- may be a sign that the central bank is still wary of bailing out bad bets by financial institutions and investors. St. Louis Fed President William Poole said in an interview on Aug. 15 that only a ``calamity'' would justify a rate cut between scheduled FOMC meetings.
`Became Unrealistic'
``They knew what they were doing'' by maintaining the anti- inflation bias at their Aug. 7 meeting, said former Dallas Fed President Robert McTeer. ``I do not agree with it, but I think they were trying very hard not to have a Bernanke put. They were hard-pressed to keep that out of it. It became unrealistic.''
Traders and economists use the term ``Greenspan put'' to describe the priority the former chairman placed on financial- market stability. A put option provides the right, though not the obligation, to sell a security, currency or commodity within a set period.
Greenspan provided ample liquidity after the 1987 stock market crash, and he was one of the architects who arranged a financial backstop for Mexico after the 1994 peso devaluation. In 1998, the Fed also helped oversee the rescue of failed hedge fund Long Term Capital Management, and cut interest rates 75 basis points in three separate moves to cushion the blow of global financial turmoil.
Former Fed officials say it's difficult for central bankers to judge when they should abandon their economic outlook, often arrived at through months of internal debate and calculation.
Fed Players
Bernanke, 53, is an expert in inflation-targeting and has spent much of his career in academia. He is flanked at the Washington-based Board of Governors by Randall Kroszner, a former University of Chicago Business School professor, and Frederic Mishkin, a monetary policy researcher and professor from the Graduate School of Business at Columbia University in New York.
Vice Chairman Donald Kohn, formerly the Fed's director of the Division of Monetary Affairs from 1987 to 2001, is the only governor with high-level experience in financial-crisis management. Kohn, 64, joined a conference call Geithner convened with bankers on Aug. 17 to persuade them to take advantage of the lower discount rate.
Geithner's Experience
Among executives of the district banks, Geithner, 46, has the most extensive background in responding to upheavals. During the Clinton years, he was an aide to Robert Rubin and Lawrence Summers, who both served as Treasury secretary. In that role, Geithner helped broker emergency loans for Thailand, Indonesia, South Korea, Russia and Brazil when their currencies sagged. While he was at the Treasury, the U.S. participated in interventions to strengthen the yen in 1998, and the euro in 2000.
``It is a team that is new to the challenge, but it is a pretty smart group,'' said Harris. Bernanke ``really studied for the job. He is familiar with the history of the Fed, the policy errors, and he is a Great Depression buff.'' Bernanke contributed to Depression research with a 1999 paper co-authored with Mark Gertler and Simon Gilchrist on how financial markets can worsen economic downturns.
With Friday's action, Bernanke and his colleagues have ``tip-toed in'' and are ``trying to strike the right balance between doing nothing and riding to the rescue,'' said Gary Schlossberg, senior economist at Wells Fargo Capital Management in San Francisco, which oversees $200 billion in assets. ``They've left the door open to a full-blown easing of monetary policy. The results are mixed so far, and early returns suggest we're not out of the woods yet.''
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