Bernanke Now Fully On Board the Rate-Cutting Bus

Was Ben Bernanke reading the New York Times yesterday? "Many on Wall Street," wrote Louis Uchitelle, "argue that with the stock market falling, unemployment rising and the economy flirting with a recession, Mr. Bernanke should be dealing with the situation more aggressively than he has so far."

What the markets were calling for, said Uchitelle, was a strong indication that the Fed was willing and ready to cut rates aggressively - to 3%, or maybe even more. Well, it seems like the markets now have that indication. Here's Bernanke, yesterday:

In light of recent changes in the outlook for and the risks to growth, additional policy easing may well be necessary. The Committee will, of course, be carefully evaluating incoming information bearing on the economic outlook. Based on that evaluation, and consistent with our dual mandate, we stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks.
Financial and economic conditions can change quickly. Consequently, the Committee must remain exceptionally alert and flexible, prepared to act in a decisive and timely manner and, in particular, to counter any adverse dynamics that might threaten economic or financial stability.

Greg Ip underlines the importance of these words:

His speech suggests he now considers weak economic growth a bigger threat than inflation, and the Fed may say so explicitly at its next meeting. That would be an important shift. In the prior five months the Fed has either called those risks balanced or refused to say which is more worrisome.

Bernanke's speech is not, in truth, as bearish as Paulson's speech was on Monday. This is as downbeat as Bernanke got:

Although economic growth slowed in the fourth quarter of last year from the third quarter's rapid clip, it seems nonetheless, as best we can tell, to have continued at a moderate pace. Recently, however, incoming information has suggested that the baseline outlook for real activity in 2008 has worsened and the downside risks to growth have become more pronounced.

Still, the markets don't really care how bearish Bernanke sounds; what matters is what he does, in terms of cutting interest rates. And the base-case scenario must now be that the Fed will cut at every meeting unless or until growth starts picking up again.

By the way, Bernanke's speech is very long, and gets nicely wonky in places. The markets only really care about the monetary-policy bits, but I was interested in this bit, too, where Bernanke explains that one reason the Fed funds rate was rather volatile in the second half of 2007 was that the Fed reduced the spread between the funds rate and the discount rate.

To maintain the federal funds rate near its target, the Federal Reserve System's open market desk must take into account the fact that loans through the discount window add reserves to the banking system and thus, all else equal, could tend to push the federal funds rate below the target set by the FOMC. The open market desk can offset this effect by draining reserves from the system. But the amounts that banks choose to borrow at the discount window can be difficult to predict, complicating the management of the federal funds rate, especially when borrowings are large.

Now that the Fed has largely replaced the discount window with the new Term Auction Facility, says Bernanke, funds-rate volatility should decline. We'll see.