Abheek Barua: Big Ben's big dilemma

Bernanke would be taking a major risk if he chose to maintain the status quo on rates.

I am not a betting man and am not offering odds on this, but I have a feeling that the "sub-prime" crisis will linger for a while now. The reason, as I see it, is not so much the existence of illiquid low-grade instruments on banks' books but the disconnect between what market participants want and the commitments that central banks, particularly the US Fed, are willing to make.

The language of the Fed minutes of its August meeting and released on August 29 is an example. While the markets expected a categorical assurance from the Fed that it would cut the Fed Funds rate (the key policy rate) when it meets again in mid-September, the Fed seemed to keep its options open. It was a classic example of central bank fence-sitting. The minutes did acknowledge the possibility of a growing crisis "" "further deterioration in financial conditions could not be ruled out and, to the extent such a development could have an adverse effect on growth prospects, might require a policy response" "" but raised the inflation bogey to leave room for holding action on rates. The asset markets reacted almost instantly. Risk aversion increased in a matter of hours as investors unwound their carry trades (investments in high-yielding assets funded from cheap yen loans).

The market reaction was a trifle irrational. The minutes referred to a meeting that had taken place on August 7, a few days before the worst of the crisis had manifested in the asset markets. The Fed had subsequently pumped in a large amount of cash in the liquidity-starved market and had pared the "discount rate", the rate it charges banks for refinance, by a half a percentage point on August 17. In short, the Fed had sent enough signals after its August 7 meeting to indicate that it was quite concerned about the state of the markets and would do its best to prevent a serious crisis. The fact that the financial market still reacted to the semantics of the meeting is an indication of how skittish they are at the moment.

Fed Chairman Ben Bernanke's speech at an economics conference on August 31 set the market's pulse racing again. While he categorically stated that the Fed would "act as needed" to preven the credit crisis from hurting the broader economy, he also slipped in the rider that "it is not the responsibility of the Federal Reserve "" nor would it be appropriate "" to protect lenders and investors from the consequences of their financial decisions".

The question is: What will the Fed do in its next monetary policy meeting? The easiest option is for it to do what the markets expect "" cut the signal Fed Funds rate. This will calm the markets down at least until the next set of expectations about monetary action builds up. The Fed can then choose to play ball or allow another phase of turbulence.

However, that could be precisely why the Fed chairman might not want to cut the rate. If the Fed gives the impression that it is entirely led by what the markets want, it ultimately loses its credibility as an effective policymaker. One of the associated problems is potential "moral hazard". If markets believe that they can always rely on the Fed to bail them out, they will continue to take more risk than they should. One could argue that former Fed Chairman Greenspan had encouraged this to a degree and that had inflated the asset bubbles (like the sub-prime bubble) that are now bursting.

Thus, to mark a decisive shift in regime, the new Fed chairman might want to hold the rate steady. Fed bosses are known to go against market expectations to signal a change in the rules of monetary policy-making. In 1979-80, then Fed Chairman Paul Volcker went against the received wisdom of the time and hiked interest rates sharply to fight an inflationary spiral that rose from rising oil prices. Volcker's actions sent interest soaring dramatically across the world, but by refusing to dismiss the oil price increases as transient shocks that could be accommodated through an easy money policy, he successfully established the US central bank's credentials as a ruthless inflation fighter. The result: long-term inflationary expectations in the US came down sharply.

Besides, US domestic fundamentals are not that dire that an immediate rate cut is warranted. The mortgage mess may have slowed consumer spending a bit but the prospect of anything close to a recession seems dim. Manufacturing growth is robust and labour markets fairly tight. July 2007 unemployment was 4.6 per cent. To put that in perspective, the unemployment rate had soared to 6.3 per cent when the economy had slowed in 2003. GDP growth for the second quarter of the year printed at a healthy 4 per cent. US companies are underleveraged and banks' net worth to assets ratio is significantly higher than the average of the 1990s. Strangely enough, despite the problems in the mortgage market, home sales have held up. New home sales in July grew 2.8 per cent, significantly higher than most economists expected.

That said, Bernanke would be taking a major risk if he chose to maintain the status quo on rates. If financial markets spin out of control and credit dries up, the repercussions for the long-term health of the US economy ultimately impact adversely on the global economic system. A rate cut at this stage seems sensible. The challenge for him is not to come across as a soft-hearted nanny that the markets and investors can turn to be at the first sign of trouble. However, the financial markets are in no mood to listen to any kind of tough talking. A rate cut may bring about temporary relief but it might just be a matter of weeks before they start fretting about the central bank's next move. That, I am afraid, will keep things volatile for a while to come.

The author is chief economist, HDFC Bank. The views here are personal