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December 9, 2007

"Bernanke Breaks Greenspan Mold"

Greg Ip says that, unlike Alan Greenspan, Ben Bernanke draws a clear distinction between financial market instability and instability in the overall economy and this gives him a different approach to policy:

Bernanke Breaks Greenspan Mold Managing Crisis, Fed Chief Dulls Notion That Turmoil In Market Leads to Rate Cut, by Greg Ip, WSJ: ...Ben Bernanke ... promised to "maintain continuity with the policies and policy strategies established during the Greenspan years." But in handling his first financial crisis, Mr. Bernanke shows signs of a break with Alan Greenspan...

That shift is important in understanding why Mr. Bernanke hasn't cut the Fed's main interest rate yet, and it could alter investors' expectations of how the Bernanke Fed will function. The Fed historically has had two major economic duties. Maintaining financial stability is one. Controlling inflation while preventing recession is the other.

To Mr. Greenspan, market confidence and the economy's growth prospects were so intertwined as to make the Fed's two duties almost inseparable. He cut rates after the 1987 stock-market crash and the near-collapse of hedge fund Long-Term Capital Management in 1998...

By contrast, Mr. Bernanke distinguishes between the central bank's two functions. So, on Aug. 17, the Fed ... action was aimed at restoring the normal functioning of disrupted credit markets, not primarily at boosting growth. The Fed, meanwhile, hasn't cut the far more economically important federal-funds rate...

To be sure, all central bankers see a link between financial and economic stability. ... But, "There's no doubt they were trying to draw a distinction between using the main tool of monetary policy, which is the federal-funds rate, and aiming the discount rate at restoring the plumbing," says Alan Blinder, a former Fed vice chairman.

To be sure, if Mr. Bernanke eventually cuts the federal-funds rate, as markets anticipate, the contrast with Mr. Greenspan will be less sharp. Mr. Bernanke will elaborate on the outlook tomorrow at the Federal Reserve Bank of Kansas City's annual symposium in Jackson Hole, Wyo. ...

Mr. Bernanke's approach to the credit crunch is, in part, an effort to undo perceptions fostered by Mr. Greenspan's rate-cutting interventions. Though successful, they drew allegations of "moral hazard" -- that is, of encouraging investors to act more recklessly because they think the Fed will protect them.

Neither Mr. Bernanke nor his closest colleagues ... believe there ever was a "Greenspan put," a reference to a contract that protects an investor from loss. Yet officials acknowledge the perception that the Fed has bailed out investors in the past. ...

Mr. Bernanke may yet have to cut rates. But the longer he waits, the more likely he can break investors of the assumption that market convulsions lead to interest-rate cuts. ...

If Bernanke has a similar emphasis in his remarks tomorrow, will expectations for a rate cut shift? As mentioned earlier, it will be interesting to see if there is any attempt to soften the widely held expectation that rates will be cut at the next meeting.

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