Fed Chairman Ben Bernanke's speech today contained three main messages, in our view: 1) a strong hint of the prospect of near-term rate cuts, 2) a reminder of the extent of the authority and flexibility bestowed on the Fed and Treasury in the recently passed Emergency Economic Stabilization Act, and 3) a commitment that policymakers will use these powers aggressively to restore market stability and mitigate the downside risks to economic activity.
Federal Reserve Chairman Ben Bernanke's remarks to the National Association for Business Economics conference in Washington today were clearly designed to soothe rattled markets. In addition to a review of the crisis thus far, and Fed and Treasury responses to it, Bernanke delivered three important messages, in our view:
1. More funds rate cuts are likely. Bernanke acknowledged that "the outlook for economic growth has worsened" and "the downside risks to growth have increased." (He suggested that "economic activity is likely to be subdued during the remainder of this year and into next year." This marks a notable shift from the minutes of the September 16 Federal Open Market Committee meeting, which suggested that growth would "pick up next year if financial strains diminish.") With the outlook for inflation improving in the meantime, "the Federal Reserve will need to consider whether the current stance of policy remains appropriate." This strongly hints at a rate cut at the Oct. 29 meeting- likely of 50 basis points or more, in our view-if not before.
2. Policymakers now have plenty of flexibility to attack market turmoil. With the authority granted in the Emergency Economic Stabilization Act to pay interest on reserves, the Fed can now expand its balance sheet as needed to provide liquidity to market participants while simultaneously keeping the Fed funds rate near target. And the Treasury now has a $700 billion war chest for its Troubled Asset Relief Program. Importantly, Bernanke added his voice to the obviously coordinated chorus of policymakers who have clarified for the market that TARP provides the authority to "directly strength then balance sheets of individual institutions." (For a note on others' comments, see our GS Skinny "Government Policy Options to Address Financial Market Stress," October 6, 2008. As if that weren't enough, President Bush explicitly mentioned the recapitalization authority in his remarks today.)
3. And are willing to use those tools aggressively. Bernanke reminded his ausience "if government intervention comes only at a point at which many or most financial institutions are insolvent or nearly so, the costs of restoring the system are greatly increased," but then went on to note that intervention has come much more quickly than in other financial crises. The Fed and other policymakers are "committed to restoring market stability and are working assiduously to ensure that the financial system is able to perform its critical economic function."
Today's equity and credit market reaction to both Bernanke's speech and the earlier announcement of the Commercial Paper Funding Facility must have come as a grave disappointment to Fed officials. Bernanke's speech suggests that Fed officials will continue to escalate their policy tools in a bid to stabilize the financial system and the outlook for the real economy. This is likely to mean additional interest rate cuts-we expect at least another 100 basis points by early next year-as well as further aggressive efforts to unclog the money markets.
Andrew Tilton/Jan Hatzius