At a Senate hearing on his nomination to head the U.S. central bank, Ben Bernanke pledged to follow the risk-management path of his predecessor, Alan Greenspan: steering policy based not only on the most likely outcome, but on less-probable, but costly, scenarios as well.
Bernanke's Fed may well be guided by that approach as it seeks a way to navigate the economy clear of financial market and housing sector turbulence at a policy meeting on Tuesday.
The Fed is widely expected to cut benchmark overnight interest rates by at least a quarter percentage point to protect the U.S. economy from rising subprime mortgage delinquencies, tighter credit and financial uncertainty.
A report last week showing U.S. nonfarm payrolls shed 4,000 jobs in August, the first drop in four years, seemed to seal the inevitability of a cut, possibly the first of several.
Policy-makers must decide how boldly to cut rates to quell what analysts warn are rising chances of a recession and weigh the risk that aggressive easing of monetary policy could overstimulate what some officials still see as a fundamentally sound economy, causing inflation to flare anew.
"If we get into a recession, given the problems in the housing market and the likelihood that we could see a very substantial increase in delinquencies and foreclosures, and through that route, downward pressures on houses, it could be a very severe recession," said former Fed Governor Lyle Gramley.
"Therefore, the difficulty of getting the economy back out of it would be much greater than the inflation problem that might develop from doing too much now," he said.
Harvard professor Martin Feldstein, who had been seen as a potential candidate to replace Greenspan before Bernanke was tapped in 2005, described a similar trade-off for the Fed in remarks at a monetary policy conference that Bernanke attended in Jackson Hole, Wyoming, this month.
Housing and mortgage market problems could lead to a freezing-up of credit, a marked consumer spending pullback and a recession, Feldstein warned.
A sharp reduction in interest rates, possibly by as much as 1 percentage point, would soften any such blows, he said. But if the impact of economic shocks failed to materialize, the result would be a stronger economy with higher inflation than the Fed wants.
That would be "an unwelcome outcome but the lesser of two evils," Feldstein concluded.
COUNTING ON A CUT
Interest-rate futures contracts show markets are tilted toward aggressive rate cuts. Futures markets have priced in a 100 percent probability of a rate cut in the overnight federal funds rate on September 18, with a better than even chance the reduction will be a relatively hefty half-point from the current 5.25 percent level in force since June 2006.
Even so, the economic picture has not been uniformly bleak.
The most recent issue of the Fed's anecdotal Beige Book, based on information collected before August 27, said that outside of real estate, indications that turmoil in financial markets had affected economic activity were limited.
Fed officials have expressed a range of views about how seriously the economy is at risk from housing and credit stresses, suggesting a lively debate on Tuesday rather than a clear, easy consensus on how deep any cuts might have to be.
Fed Governor Frederic Mishkin said possible business and consumer retrenchment poses an important downside risk to the economy. In contrast, Dallas Federal Reserve Bank President Richard Fisher was upbeat. "Our economy appears to be weathering the storm thus far," he said.
Fed officials may want to move at a measured pace once they begin to cut rates but signal to markets through their habitual post-meeting statement that more easing could lie in store.
"Weakness in recent labor data, coupled with continuing distress in the housing markets, should allay any lingering concerns about over-stimulating the economy," Ken Hackel and Arohan Kohli of RBS Greenwich Capital wrote in a note to clients on Monday. "As a result, the stage is set for lower official rates at the September meeting, along with some assurance that more assistance will be provided if necessary."
In December 2000, just before the Fed embarked on its last rate-cutting campaign, the policy-setting Federal Open Market Committee said it would "continue to monitor closely the evolving economic situation." It dropped rates two weeks later in a surprise intermeeting move.
The central bank could use similar language in its statement on Tuesday to indicate a willingness to move swiftly with further rates cuts if needed.
Resistance from some Fed policy-makers may not be the only restraining factor that would seem to favor only a quarter-point cut. Some officials may also have a lingering reluctance to take steps that could be seen as providing relief to investors who underestimated risks.
"The Fed does not want to cut the fed funds rate but it may well be forced to because of the inevitable slowdown in U.S. economic activity arising from the subprime-induced credit crunch; but Ben Bernanke has made it very clear that he will not bail out imprudent lenders and investors ... by aggressively easing monetary policy," Sherry Cooper, chief economist for BMO Capital Markets wrote on Tuesday.
The Fed may continue to use tools aimed specifically at restoring liquidity to credit markets -- like further cuts to the discount rate that governs direct Fed lending to banks -- to calm mortgage and commercial paper markets, rather than cutting the interbank federal funds rate, she said.