Extraordinary circumstances call for decisive action, and the Fed is doing just that. It is just too early to judge Ben Bernanke, says Vivek Sharma

Damned if you do, damned if you don't. That is the predicament of the modern central banker in this age of information deluge, when just about anyone can anoint himself or herself a policy guru. Every action by the central bank is perceived as pampering someone or the other and it will be blamed for losing its spine and much more. When there is no action, the central bank is blamed for 'insensitivity', being behind the curve and 'lazy' monetary policy.

What media commentators and the millions of analysts forget is that central bankers also happen to be humans. They don't have any divine powers to foresee the future and then make policy adjustment in the present. If that was the case, they would always be right and there would be no need for us to analyse their actions! All they can do is 'guessimate' the likely future trends in economic growth and inflation from available data, and act accordingly. Just like the rest of us, they are prone to errors of analysis and judgement.

But, if they stick to their mandate and draft their policies accordingly, they are likely to do more good than harm. With luck, some central bankers may be perceived as geniuses of their trade. But, the legacies of even those geniuses will be questioned long after they have left the scene - as Alan Greenspan is learning now, much to his dismay.

When the Fed brought down its target fund rate by 75 basis points last week, most commentators and economists were highly critical. 'Excessive', 'reckless' and 'damaging' were some of the terms used to describe the Fed move by analysts, who were near unanimous in saying Bernanke panicked when global equity markets sold off sharply.

Another interesting allegation was that the Fed was tricked into a big cut by the heavy unwinding of positions by SocGen, the French bank hit by fraudulent trades by an employee, which caused the global equity meltdown before the Fed cut. But markets had turned weak even before SocGen started the unwinding of derivative positions. Yes, SocGen's troubles might have accentuated the fall, but markets were mostly reacting to distressed economic signals.

Reactions to the Fed's latest 50 points cut are no different. The same allegations are being repeated - that Fed policy is enslaved to market demands, Fed is pursuing a dangerous policy, inflation will be unmanageable and so on.

What else could Bernanke do?
When the Fed started the current policy easing with a 50 points cut last year, there were many who said the move was excessive. The US economy was still doing reasonably well and the rest of the world never had it better. Yes, housing was weak - but it was only a 'sub-prime' problem and not yet the 'credit contagion' it later mutated into. Equity markets were showing some of a correction, after a multi-year rally. Obviously, Bernanke is doing this to prop up the markets - the commentators said.

The subsequent market rally, especially in emerging markets like India, made this argument all the more convincing. Investors and traders loved it and asked for more.

Isn't it more likely that the Fed correctly judged that US housing woes could get worse, and went in for a 50 points cut? Considering that US housing got much worse that anyone anticipated, wasn't it the best possible monetary policy move at that point? The move did blow up the emerging market equity bubble, but the credit crisis might have been much worse if the Fed had not acted then. 

The first move was followed by two subsequent rate cuts of 25 basis points each. This time, commentators on the other side went on the offensive and accused the Fed of failing to grasp the enormity of the crisis and not being aggressive enough. Markets were not pleased, as they were clamouring for more.

But, inflation risks were high enough and employment was still strong - something the Fed could not ignore. After a major rate move, most central bankers would prefer to wait and measure the impact before making their next big move - especially when the environment is highly uncertain. That is exactly what the Fed did. As US housing sector continued to weaken, the Fed lowered rates - but more cautiously as it was worried about inflation.

Then came the spectacular bank write-downs. When major banks made large provisions for CDO write-downs during the third quarter, most analysts were confident that they were enough and last quarter write-downs won't be bigger. Nobody could have foreseen the substantially higher provisions that were required later, not even the Fed.

Then came the bond insurers scare. Most knew that bond insurers will rack up huge losses from CDO underwriting, and their stocks were pummelled. But, not many could imagine that they will find it difficult to raise additional capital and could end up losing their AAA rating - forcing bond investors to write-down the value of their holdings.

On hindsight, the Fed could have been more aggressive with the rate cuts. But, that is like saying World War II could have been avoided if someone had killed Hitler before the war. The events unfolded at a very rapid pace and economic data was inconsistent enough to challenge even the best central bankers.

Faced with a recession, rates have to be cut
US GDP growth for the last quarter of 2007 was a meagre 0.6 per cent, less than half of most forecasts. That is close to a standstill and supports some of the most pessimistic forecasts for the current year. Unemployment has started rising and housing is yet to see a bottom. Downgrades by rating agencies continue, the move by S&P on securities worth more than $500 billion being the latest. Not even the banks know if they have to write-down more.

Given this scenario, can the Fed be faulted for bringing down the rates aggressively? Real interest rates, after adjusting for inflation, are close to zero. When the economy has stopped expanding, and looks all set to contract, isn't that the appropriate monetary response?

The rate cuts, by a total of 125 basis points in less than two weeks, are indeed dramatic. But, so are the economic conditions in the US. If the US economy slips into a recession this year, it will be the first simultaneous decline in US household wealth and income in more than three decades.

There are many who want the Fed to go slowly, in a more calibrated fashion. When the economy is slipping fast, what good will measured rate cuts do? If the Fed is doing something, it better be significant enough to make an impact.

Inflation could yet make Bernanke a villain
Like most bold moves, recent rate changes by the Fed are also fraught with considerable risks. Inflation looks manageable, but certainly cannot be ignored. Oil prices may have come off record highs, but are still high enough. Same goes for food and commodity prices.

Unlike in earlier cycles, higher demand from rest of the world could support commodity prices even when the US is in a recession. Rate cuts may also lead to further dollar weakness and higher commodity prices, pushing up inflation. That would make the down turn even more painful.

Extraordinary circumstances call for decisive action, and the Fed is doing that. When that is the case, it is unfair to criticise all the Fed moves as attempts to appease financial markets. These rate cuts may prove to be insufficient to avert a recession, and may even turn out to be disastrous if inflation goes out of control. But, there is no way we can predict the future - especially when the environment is getting more complex by the day.

It is just too early to judge Ben Bernanke.