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Bernanke Walks the Hawk

Tony Crescenzi

Fed Chairman Ben Bernanke sounded characteristically hawkish in his speech before the Italian American Foundation moments ago, continuing a strategy begun in earnest in September when Fed Vice Chairman Don Kohn signaled to the markets that its expectation for a near-term interest rate cut was wrongheaded.

Bernanke's speech today was airtight, with the chairman leaving virtually no room for investors to conclude that the Fed is contemplating an interest rate cut. Ostensibly, the Fed's strategy is to lock in gains that it has made on inflation and inflation expectations. The Fed is taking no chances.

Bernanke's comments are consistent with what the markets are already priced for; chiefly, that the Fed will not act on interest rates for six months. Moreover, with the inflation rate falling, the real fed funds rate (the fed funds rate minus inflation) is rising, meaning that Fed policy is getting tighter.

The markets are priced for this tightening of policy via the inverted yield curve, the inverted spread between Treasuries and the fed funds rate, and the TIPS market.

Many are perplexed as to why it is that the Fed has left so little room for speculation about an interest rate cut despite both the slowing in the economy and the lowering of the inflation rate and inflation expectations.

Again, the main reason seems to be that the Fed wants to guard the gains that it has made on the inflation front and gain credibility for the promulgation of the Bernanke era. In addition, the Fed need not signal an interest rate cut. Rate cuts are "good" news and needn't be signaled in the same way as interest rate hikes must be. The Fed can deliver its cuts either by surprise or on short notice.

Moreover, if the Fed were to signal its interest rate cuts too soon, financial conditions would loosen perhaps too much, too soon. Stock prices would rise, bond yields would fall, the dollar would fall, credit spreads would tighten, and bank lending standards would loosen.

All of these conditions would be conducive to stronger growth, something that the economy does not yet need because a small buildup of economic slack is needed to fully wring inflation from the system.