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Fed chairman's efforts to clarify throw off markets

WASHINGTON—In his fifth month on the job, Federal Reserve Chairman Ben Bernanke is learning the hard way that his pledge to make America's monetary policy clearer comes with a price.

Bernanke became chairman on Feb. 1, and he's off to a rocky start after roiling the markets in recent weeks. His sin, it seems, is speaking too clearly about interest rates and inflation, as he promised to do after taking the helm from the opaque Alan Greenspan, who turned vague statements into an art form.

The new chairman's rough patch began on April 27, when he signaled before the Joint Economic Committee of Congress that after 16 consecutive interest-rate increases since June 2004, a pause might be in order. Stocks rallied.

Days later, however, in what he thought was a private conversation with a CNBC reporter, Bernanke said that the markets had misunderstood his message and that a pause was in no way certain. CNBC reported it on May 1, sparking a Wall Street roller-coaster ride.

Soon after, data came out suggesting that energy prices were driving inflation to the upper limits of the Fed's comfort zone. The implication: A late June rate increase was now more likely than a pause.

Bernanke's words in April had proved too optimistic, given that the Fed's main mission is to quell inflation, primarily by setting short-term interest rates.

Testifying before the Senate in late May, Bernanke apologized for "a lapse in judgment on my part" in talking loosely to a reporter. In the future, Bernanke said, he'd stick to formal channels to communicate to the public.

But even speaking that way roiled the markets. In a speech to a Washington conference on Monday, Bernanke left little doubt that future rate increases should be expected because price inflation had reached a danger zone.

The Fed chief also said that the U.S. economy is showing signs of slowing down. He pointed to slowing consumer spending, the cooling housing market and slower job growth. A slowing economy normally prompts an end to rate increases or spurs rate cuts to rekindle economic embers. But Bernanke left no doubt that he's more worried about rising inflation than slowing growth—and their combination is troubling.

"These are unwelcome developments," he said.

The Dow Jones industrials promptly plunged 200 points, and stocks slumped further through the week. What the markets heard was that rate hikes might extend beyond the next expected bump up to 5.25 percent at the Fed's June 28-29 meeting.

Why such volatility? Bernanke, after all, was just engaging in the "plain speak" he'd promised.

Blame Greenspan, who for more than 18 years as Fed chairman developed an oft-impenetrable language to communicate the Fed's thinking.

"I guess I should warn you, if I turn out to be particularly clear, you've probably misunderstood what I've said," Greenspan once famously quipped.

The markets, it appears, don't want straight talk.

"The markets and Bernanke haven't quite learned how to listen to each other," said James Glassman, a senior economist for investment bank JP Morgan Chase. "I'm sure he thinks he's leaving the door open ... but the market needs simple messages, and the markets have sort of been used to getting spoon-fed."

The danger in Bernanke's plain talk is that it creates expectations that can be dashed by new contradictory data. When he said that future Fed rate decisions would be dependent on emerging data but looked favorable for a pause, he didn't leave the Fed much wiggle room for unexpected data—as the next set of inflation numbers promptly proved.

Greenspan avoided trapping himself in pronunciations that upset the markets, preferring carefully worded vague statements that led market analysts to debate endlessly what he meant. That left him room to act as he saw fit.

Bernanke's signals, on the contrary, set off market forces that now complicate his future rate decisions.

Two prominent former Federal Reserve governors interviewed by Knight Ridder suggested that Bernanke's problems are less self-inflicted than a reflection of how difficult it is to determine when to stop raising interest rates.

"The problem here is that Bernanke came in when the easy work was over. Bernanke was not able to give the kind of more precise guidance" that comes earlier in a rate-raising cycle, said Laurence Meyer, a Fed governor from 1996 to 2002.

Conducting monetary policy is like navigating in fog.

The Fed is believed to be near the so-called neutral zone, where interest rates are high enough to keep inflation in check but not so high as to harm the economy. But rate increases have a delayed effect on the economy by slowing growth months later. The delay is precisely why Fed policymakers never quite know when to stop.

Raise rates too long and you harm the economy. President George H.W. Bush believed Greenspan cost him the 1992 election by not lowering interest rates fast enough.

Fail to raise rates enough and price inflation can take off. Once inflation kicks in, rates have to rise further to restrain it, which can kick the economy into recession. The late ྂs and early ྌs tell that tale.

"If you don't go far enough, inflation expectations become unanchored and it takes a long time to repair," Meyer said.

"Everybody who has ever been at the Fed says policymaking gets more difficult around turning points," said Edward Gramlich, a Fed governor from 1997 to 2005 who's now an economics professor at the University of Michigan. "It also gets more difficult where needs from the standpoint of the real economy and (fighting) inflation may diverge."

Today, those diverging demands are a slowing economy, which makes the case for a pause in rate increases, and rising inflation, which demands that they continue.

Pause or raise? The question likely would have bedeviled Greenspan today much as it does Bernanke, said Gramlich.

"When you get to the end of the cycle, there's a lot of uncertainty," he said. "You don't want to mislead people, but you don't really know how much further rates have to rise."

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For a copy of Bernanke's Monday statement, go to:

www.federalreserve.gov/boarddocs/speeches/2006/20060605/default.htm

For a copy of his April testimony, go to: www.federalreserve.gov/boarddocs/testimony/2006/20060427/default.htm

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(c) 2006, Knight Ridder/Tribune Information Services.

ARCHIVE PHOTOS on KRT Direct (from KRT Photo Service, 202-383-6099): Ben Bernanke

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