US: Bernanke's dilemma

Wednesday June 25

Ahead of the presidential election in November, Federal Reserve Chairman Ben Bernanke faces a policy dilemma. As the Federal Reserve's Open Market Committee meets today, he will know that maintaining interest rates at their presently low levels runs the risk of weakening the US dollar and boosting inflationary expectations. However, reversing recent interest rate cuts risks accentuating the housing and credit market busts, and prolonging the economic downturn.

Terrible policy environment. Over the past year, the Fed has confronted the most challenging policy environment in recent memory:

• Housing bust. The country is in the midst of the worst housing market collapse in the past 60 years, epitomised by accelerating price declines at the national level and surging mortgage foreclosures.
• Credit crunch. The credit contraction that began in August 2007, in the wake of the large sub-prime mortgage losses recorded by the financial system, has resulted in a dramatic tightening in bank lending standards. Former Fed Chairman Alan Greenspan now characterises this event as the most wrenching crisis of the post-war period.
• Oil price shock. Adjusted for inflation, oil prices have increased over the past twelve months by more than they did during the 1979 oil price shock, which produced a global economic recession.

Dollar weakness. Another factor complicating the Fed's policy dilemma is continued downward pressure on the dollar. In addition to stoking domestic inflation through increased import costs, a weak dollar is now seen on Wall Street as a factor fuelling the oil price boom.

Political dimension. Ahead of the presidential election in November, the Fed will need to proffer very compelling reasons to reverse the recent round of interest rate cuts. The Fed knows that it potentially faces political attacks -- emphasised pointedly by Senate Banking Committee Chairman Christopher Dodd's refusal to act on two of President George Bush's appointments to the Board of Governors. Political considerations likely mean that the Fed would prefer to wait until after the elections before raising interest rates.