The Fed chairman testifies before the congressional Joint Economic Committee Thursday, and will no doubt face tough questions about how the central bank is addressing renewed credit concerns that have wiped out billions of dollars in bank profits and cost two high-profile Wall Street CEOs their jobs.
Many investors are discounting data suggesting the U.S. economy is safely navigating a housing recession, and pleading for further interest-rate cuts to stave off what they fear will be an inevitable hit to the economy from tighter credit. But, mindful of the past, the Fed seems eager to hold the line.
Fed Governor Frederic Mishkin Monday acknowledged that a stable financial system was critical to the economy's health.
However, he also noted that "unwelcome inflationary pressures" can build when central bankers act too aggressively to avert downturns, saying they must be prepared to reverse course.
"If, in their quest to reduce macroeconomic risk, policy-makers overshoot and ease policy too much, they need to be willing to expeditiously remove at least part of that ease before inflationary pressures become a threat," he said.
Looking for Balance
Goldman Sachs economist Jan Hatzius said those comments set the stage for testimony from Bernanke emphasizing a balance between nagging inflation concerns and threats to growth as the economy bends under the weight of a housing-market recession.
"Even Governor Mishkin -- who has been very much 'out in front' of the (Federal Open Market) Committee in arguing for pre-emptive easing -- gave an even-handed speech ... that contained no strong hints of further rate cuts, and Chairman Bernanke may follow with similar commentary," Hatzius wrote in a note to clients.
Recent economic data shows a resilient U.S. economy, with modest growth in manufacturing, employment and income, which bolsters the Fed's case for keeping its options open at its next interest-rate setting meeting in December.
But Citigroup's warning that it will write off as much as $11 billion in bad debts tied to subprime mortgages strengthened Wall Street's call for another rate cut.
"The financial markets are trying to push the Fed to continue to lower the fed funds rate once again, even though the Fed was clear in that it was going to pause and wait for information that proved them wrong," Eugenio Aleman, senior economist at Wells Fargo, wrote in a research note.
Flashing Back to 1998
The rift between benign economic data and market fears of worse to come calls to mind 1998, when the Greenspan-led Fed cut rates by three-quarters of a percentage point in the span of about seven weeks out of concern that contagion from the Asian financial crisis, Russian default and the collapse of hedge fund Long-Term Capital Management would curb growth.
Like now, those cuts were aimed at forestalling the impact tightening credit could have, even before data showed any significant weakness. That time, the economy rebounded much faster than the Fed had anticipated, and the central bank turned heel and began raising rates about a half year later.
"There's certainly some lessons from the past to suggest that often the broader economy is much more resilient than either Wall Street or the Fed give it credit for," said Julia Coronado, a former Fed economist now with Barclays Capital in New York. "Certainly, everything we're seeing in the real economic data points to that."
The Fed Giveth...
The memory of 1998 seems to be fresh in the minds of some policy-makers, as well.
"Past experience does show that financial turbulence can be resolved more quickly than seems likely when we're in the middle of it," San Francisco Federal Reserve Bank President Janet Yellen said in September, shortly before the Fed cut interest rates by a bold half-point.
"Moreover, the effects of these disruptions can turn out to be surprisingly small. A good example is the aftermath of the Russian debt default in 1998. Many forecasters predicted a sharp economic slowdown as a result; but instead, growth turned out to be robust," she said.
Indeed, many critics charge that the Fed waited too long to remove the monetary stimulus it put in place in 1998, helping fuel a technology stocks bubble that later popped and contributed to an ensuing recession.
Some analysts are raising similar red flags this time around, arguing that the Fed has eased more than enough as soaring oil prices, a free-falling dollar and a tight labor market threaten to push inflation higher.
If the Fed is looking to 1998 as a guidepost, investors banking on rate cuts are likely to be disappointed should fourth-quarter economic data not live up to dire expectations.