Ben Bernanke has a dilemma. The chairman of the Federal Reserve Board should, but should not, cut overnight interest rates this year. It’s a problem that is making financial markets look less secure. He should cut because US growth is slowing. Orders for capital equipment have declined for two months and the homebuilding sector is in trouble, not to mention the financial difficulties that might flow out of the subprime mortgage meltdown.
But he should not cut because inflation is well above the 2% rate that makes central bankers comfortable. The so-called core CPI rate, which excludes the price of energy and food, has been above 2.5% since January 2006.
Bernanke testified to Congress on 28 March that the core inflation rate would soon be ebbing, but it’s hard to see why that should happen. For now, Bernanke seems to have decided that inaction is the better part of valour. But his unwillingness to endorse the market hypothesis of rate cuts in 2007 is making investors jittery. They have been counting on the “Bernanke put”, the willingness of the central bank to lower rates whenever growth slows too much or financial troubles develop. Such a rescue now looks less certain.
When investors feel less secure, they tend to get jumpy. That helps explain why the price of oil leapt 7% in seven minutes on Tuesday, the fastest increase in memory, on nothing more than an unlikely rumour of an Iranian attack on a US warship. The oil panic subsided quickly, but the end of the Bernanke put could have more durable effects. After all, if the central bank withdraws a financial safety net, risky investments get riskier.
So it not surprising some yen carry trades-borrowing at low interest rates in yen and lending in higher-yielding currencies are being unwound. The yen rose almost 1% against the dollar after Bernanke’s testimony. Markets have mostly recovered from their February wobble. But that was caused by a disruption in the small and illiquid Shanghai stock exchange.
Troubles in the US are a much more serious matter.