- The Washington Times - Monday, December 14, 2009

The Black Monday stock-market plunge that greeted Alan Greenspan in 1987 was a breeze compared with the hurricanes that confronted Ben S. Bernanke during his first term as Federal Reserve chairman.

In fact, if you added up all the crises that Mr. Greenspan faced during his 18 years as Fed chairman — Black Monday, the savings and loan blowout, the Mexican peso debacle, the Asian financial meltdown, the implosion of Long-Term Capital Management and the Sept. 11, 2001, terrorist attacks — it would still be tough to approach the challenges that Mr. Bernanke has been forced to address.

Amid the worst financial meltdown since the 1930s, more than a few sober-minded economists, including Mr. Bernanke himself, feared that the crisis could have led to “Great Depression 2.0.”

So far, economists say, the danger of a depression has been averted.

At his reconfirmation hearing last week, Mr. Bernanke pointed to the “central role” the Fed has played in avoiding an “outcome that could have been markedly worse.” Those actions, which included unpopular bailouts of Wall Street firms whose excessive risk-taking contributed to the crisis, “were unfortunately necessary to prevent a global economic catastrophe that could have rivaled the Great Depression in length and severity,” Mr. Bernanke recently noted.

Nonetheless, the U.S. economy has suffered its deepest recession since the 1930s, and although an economic recovery appears to be emerging, “We still have some way to go before we can be assured the recovery is self-sustaining,” Mr. Bernanke told the Economic Club of Washington on Dec. 7.

The economy expanded at a 2.8 percent annual pace during the July-September period, and the unemployment rate declined from 10.2 percent to 10 percent last month. But economists, including those at the Fed, expect the jobless rate to remain at high levels through the end of 2010.

In the likely event that the Senate votes to confirm Mr. Bernanke for a second term, he and the Federal Reserve will continue to face huge challenges on the political front, as well as in the economic arena. Those challenges derive directly from the unprecedented actions Mr. Bernanke and the Fed have undertaken since the summer of 2007 to address the economic crisis.

“There are a number of major initiatives afoot in the Senate and the House that could potentially create major problems for Bernanke in the future,” said Brian Bethune, chief U.S. economist for IHS Global Insight.

Many in Congress blame the Fed for failing to exercise its regulatory and supervisory powers before the crisis erupted, especially in the mortgage markets.

Congress is now moving to remove the Fed’s powers over consumer protection and create an independent consumer agency. Congress may also drastically reduce the central bank’s role as a systemic regulator. Mr. Bernanke strongly opposes both actions.

Also on the political front, Rep. Ron Paul, Texas Republican, secured more than 300 co-sponsors for his bill to empower a congressionally approved agency to “audit” the Fed’s monetary policy decisions involving interest rates. Mr. Bernanke argues that such political pressure would compromise the Fed’s credibility and independence. But the House Financial Services Committee recently adopted Mr. Paul’s bill as an amendment to its regulatory-reform bill.

“Bernanke made a strong case against both a Senate proposal to strip the central bank of its authority to supervise banks and a House proposal to audit the central bank’s interest-rate decisions, contending such proposals would reduce the Fed’s ability to make monetary policy and ultimately harm the economy,” said Joseph Brusuelas of Moody’s Economy.com.

Mr. Bernanke was upbraided about the Fed’s performance before the crisis erupted.

“For many years I held the Federal Reserve in very high regard,” Sen. Richard C. Shelby, Alabama Republican and ranking member of the banking committee, said at the confirmation hearing. “I fear now, however, that our trust and confidence were misplaced.”

Mr. Bernanke acknowledged some culpability.

“There were mistakes made all around,” Mr. Bernanke said at his hearing. “I did not anticipate a crisis of this magnitude and this severity.”

After the housing bubble began to deflate in mid-2006, for example, Mr. Bernanke was much too slow to recognize its impact on the U.S. and world economies.

“At this juncture,” Mr. Bernanke told the Joint Economic Committee in March 2007, “the impact on the broader economy and financial markets of the problems in the subprime markets seems likely to be contained.”

After banks and hedge funds began suffering multibillion-dollar losses from subprime securities, and after the credit markets seized up in August 2007, the Fed was too slow to lower its benchmark short-term interest rate — the federal funds rate — from 5.25 percent, critics have complained.

Mr. Bernanke’s supporters, however, noted at the time that inflation was running at 2.7 percent. Thus, the inflation-adjusted Fed funds rate was about 2.5 percent, hardly restrictive for an economic expansion approaching the end of its sixth year. Moreover, the price of oil on the New York Mercantile Exchange had jumped from $50 per barrel in January 2007 to nearly $80 in August, threatening an outburst of inflation.

By September 2007, as credit markets tightened further, Mr. Bernanke and the central bank began to aggressively reduce the overnight federal funds rate. By the end of 2008, the overnight rate was between 0 and 0.25 percent, where it has remained ever since.

The Fed also began creating the first of numerous extraordinary “liquidity facilities” to provide cash to credit-starved markets. In the process, the Fed expanded its balance sheet from less than $900 billion to more than $2.2 trillion.

As the housing market continued spiraling downward, the Fed announced a program in November 2008 (and expanded it in March 2009) to purchase a total of $1.25 trillion in mortgage-backed securities from Fannie Mae and Freddie Mac. The Fed also pledged to purchase $200 billion in Fannie and Freddie debt securities and $300 billion in long-term Treasury securities.

The goal of this unprecedented $1.75 trillion effort was to drive down long-term interest rates, especially mortgage rates. The average interest rate for 30-year fixed-rate mortgages fell to 4.71 percent in early December, its lowest level in the 38 years Freddie Mac has been tracking rates and 1.8 percentage points below the average rate in August 2008.

On the economic front, Mr. Bernanke would spend much of his second term reversing the policies the Fed pursued during the past two years. Mr. Bernanke calls this his “exit strategy.” He maintains that the Fed is well-positioned to remove the tremendous amount of liquidity it has injected into the economy and housing market before it fans the embers of inflation.

As the Fed ends its program with Fannie and Freddie and unwinds its positions with the two mortgage-financing giants, mortgage rates are likely to rise, said Brian Sack, executive vice president of the Federal Reserve Bank of New York. That could short-circuit a budding housing recovery.

Eventually, the Fed will need to raise short-term interest rates as the economic recovery gains steam. Rates might have to rise before the unemployment rate falls substantially, and that would likely aggravate tensions with Congress and the White House.

If the Fed acts too quickly, it could jeopardize the recovery and push the economy into another recession. If it waits too long, inflationary pressures could break through, sending prices spiraling upward.

Throughout a second four-year term, massive budget deficits, which the administration says will average more than $1 trillion per year, will cast a huge shadow over the Fed’s operations.

As the economy expands, businesses will increase their borrowing, and lenders, including foreign investors who own about half of the government’s publicly held debt, may demand higher interest rates. That would increase costs for both the government and the private sector. Mortgage rates could jump.

An already bulging budget deficit would expand further, while economic activity would slow down as investment projects are shelved because of higher interest rates. Policymakers could confront another recession long before the unemployment rate had significantly declined below today’s double-digit level.

Suddenly, Mr. Bernanke’s second term as Fed chairman could begin to resemble his first, something nobody wants to contemplate.

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