The speeches of Federal Reserve officials rarely contain startling insights or reveal unexpected changes in monetary policy. Officials understand the power their words have to move financial markets, and they also understand the Law of Unintended Consequences. Any deliberate attempt to influence the markets in one direction could just as easily produce the opposite result. This morning’s address by Fed Chairman Bernanke was true to form. There were no big surprises, but a great deal of reassurance that the Fed and the markets are looking at the economy essentially in the same way. The key takeaways from the speech are:
1. An acknowledgment that ensuring “that financial markets function in an orderly manner” is part of the Fed’s mandate. For the last few years, Fed officials have sought to narrowly define their role as maintaining price stability and low inflation. This wider outlook is highly welcome.
2. An acknowledgment that “developments in the financial markets can have broad effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy.” The collapse of the subprime market has sharply impaired liquidity and the appetite for risk that healthy market economies require. The consequences are hardly limited to hedge fund managers and CEOs of subprime loan companies. Thousands of ordinary people have already lost their jobs and 401(k)’s have been devastated. Bernanke has now put himself on record as realizing the far-reaching implications of the crisis.
3. Bernanke closed the section of his remarks dealing with recent developments in the financial markets with this sentence: “The Committee continues to monitor the situation and will act as needed to limit the adverse effects on the broader economy that may arise from the disruptions in financial markets.” This sure sounds like it could be the conclusion of the statement following the September 18 Federal Open Market Committee meeting announcing a cut in the fed funds rate.
Fed funds futures have now priced in a 64% chance of a 50-basis point cut and 36% chance of a 25-basis point cut in September. Adding weight to this sentiment is today’s report that the core Personal Consumption Expenditure deflator, the Fed’s favorite inflation gauge, increased just 1.9% year-over-year. This index has been falling since February. July was the second month in a row it was below 2%.