Bernanke's bold and unorthodox steps in recent months seem to have calmed down the credit markets and yesterday's 25 basis points cut was widely expected. But, his biggest test has yet to come. By Vivek Sharma

Yesterday's FOMC, the interest rate policy setting committee of the US Fed, meeting was probably the calmest since the credit bubble burst on the world's face last year. Though they are quite far from being normal, credit markets have calmed down, the US dollar has stabilised, corporate and home mortgage borrowing costs have come down and equity markets seem to be stabilising. Though large commercial banks continue to provide astronomical sums to cover their exposure to credit derivatives, the panic seems to have subsided.

There are many who now believe that we are past the credit crisis bottom and a slow recovery is already underway. They point out that no big bank has actually failed, or has not been allowed to fail by the mighty central banks. Corporate earnings have been expectedly weak, but are not that disastrous. There are pockets of strong performance, like technology and high-end manufacturing.

The US economy did not contract in the Jan-March quarter as most feared. Though the 0.6 per cent annualised growth for the quarter was only because of the rise in inventories, it is still not a recession – at least theoretically.

Private equity investors are again testing the waters and big corporate deals are being announced, like the $22-billion takeover of confectioner Wrigley's by competitor Mars – backed by none other than Warren Buffet (See: Warren Buffet, Mars acquire Wrigley for $22 billion). 

Large institutional investors are still raising big money – Warburg Pincus last month raised as much as $15 billion for a new global fund (See: Warburg Pincus raises $15 billion in new fund; exceeds target) and the Citigroup yesterday said it had raised $4.5 billion from a stake sale, against the planned $3 billion (See: Citigroup stake sale fetches $4.5 billion; exceeds target by 50 per cent).

This cannot be a recession, can it?

The price of stability
Of course, the Fed had to sweat a lot to achieve what appears to be a gradual process of the credit markets returning to calmer shores. Under Chairman Ben Bernanke, the Fed has cut rates even faster than it did post-9/11, under his predecessor Alan Greenspan. The short period since September 2007 has seen the Fed fund rate drop from 5.25 per cent to 2 per cent after yesterday's move. This period also saw the Fed rate being cut twice by 75 basis points each, a significantly large move often considered to happen only once in a lifetime.

Bernanke, strongly backed by treasury secretary Paulson, also ventured into areas where the Fed had never ventured. He pushed the envelope of Fed's role by extending the discount facility, traditionally available only to commercial banks, to prime brokers as well.

When one of the big Wall Street firms, Bear Stearns, seemed all set to go under, Bernanke stepped in and facilitated its takeover by J P Morgan by guaranteeing a big chunk of dubious paper in Bear's books. In doing so, the Fed exposed itself to credit risks it had never dared touch in the past.  (See: US Fed clears JP Morgan's acquisition of Bear Stearns bank)

Bernanke has also staked his own professional reputation and career in his rather daring steps to avoid financial disasters. In the process, he has been pilloried by critics who still believe that this crisis is best handled by proven, age-old monetary tools. They have accused Bernanke of taking extremely risky steps, which will exacerbate the crisis if they don't play out the way they are expected to do. 

All said and done, Bernanke has survived so far and his measures seems to be working to the extent the credit markets have calmed down. Though the long-term impact of the Fed's recent policy initiatives are difficult to measure at this point, and may have some harmful effects down the road, they appear to have stemmed the tide. It is quite possible that more disasters lie ahead and markets may slip back to turmoil. Yet, at this moment, Bernanke can afford to breathe a little easy though his critics will continue to whine.

The equilibrium call
Cutting interest rates drastically and taking other dramatic steps to manage the credit crisis might have been the easy steps. It is trickier to take a call on how much is enough, when to stop and when to reverse course. It is safe to assume that the Fed has achieved its short-term objective, which is stabilizing the market. That means no further drastic steps are required at this point, unless there is another Bear Stearns around the corner and someone calls the Fed and says, 'Ben, we have a problem'.

Though the US economy did expand by an annualised 0.6 per cent last quarter, the outlook remains very cloudy. There is no recovery in sight in the housing market and consumer sentiment has slipped to it lowest level in recent years. To make it worse, business sentiment has also worsened. The Fed acknowledged this in yesterday's policy statement by saying 'household and business sentiment has been subdued'. The reference to business spending was absent in the last statement and hence assumes significance.

Therefore, only a modest measure was called for at this point and that is what the Fed has delivered with the 25 basis point cut in target rate. It was also the easiest of the Fed's recent decisions to take, something which was fully factored in by the markets.

Reversing the cycle
The bigger challenge now for Bernanke is to decide whether the 2-per cent Fed funds rate should be the bottom and when to reverse course and start monetary tightening. Markets believe, going by the futures market data, that yesterday's move was the last from the Fed for many months to come. There are some solid reasons for believing so.

For a variety of reasons, commodity prices have continued to rise even as the global economic outlook has worsened in recent months. Oil is now around $120 per barrel, a level almost unimaginable even last year, while metal prices have firmed up again after a modest correction. The rise in food prices is even more alarming and, given its impact on the low income population, more significant from a policy perspective.

Naturally, governments and central banks the world over are quite worked up over the alarming rise in prices of basic goods. While the Fed's latest statement has more or less repeated it's earlier inflation outlook – core inflation readings have improved and we expect inflation to moderate in coming quarters – the Fed must be concerned about inflation risks, especially since the outlook appears to be quite uncertain.

When oil touched $100 per barrel, it was blamed on speculative excesses and most expected a good correction to levels below $80. That has not happened and prices have continued to surge even though there is no perceptible change for the worse in the supply situation.

Oil cartel OPEC now says prices could hit $200 per barrel and it can do nothing about it. Having run out of theories, the US recession is now being blamed for the rise in oil prices. According to this view, the weaker dollar is the main driver of oil prices – according to OPEC's president every 1 per cent fall in the dollar's value push up oil price by $4 per barrel! While there is some merit in this theory, it is lost on American consumers who now pay close to $4 per gallon of petrol.

The higher oil prices continue to encourage diversion of more quantities of grains to bio-fuel production and push up grain prices. Apart from being highly politically sensitive, higher grain prices have a disproportionate effect on inflationary expectations. More than the current inflation, expectations about the future price rise are more dangerous. Consumers start hoarding basic staples, which push up prices even further. This has already started happening in the US and big retailers like Wal-Mart are now restricting the quantity of staples individual consumers can buy.

This will be Ben Bernanke's biggest test – to decide when and how fast to begin raising  interest rates to curb inflationary pressures, if they show signs of going out of hand. As the Fed noted in its statement, core inflation – excluding food and fuel – has actually moderated. Hence, the situation is not as alarming as some inflation hawks make out to be.

But, the risks of an upside are quite high and the Fed has to be guarded and prepared to step in when necessary. When that moment comes, Bernanke must prove that he can also do a Volcker  (former Fed chairman who raised interest rates even as the economy slipped into a recession) and ruthlessly hike interest rates to kill inflation.