Bernanke's First Big Test

Aug. 7, 2007 — -- The Federal Reserve will meet this afternoon in one of the most important and most anticipated meetings in months.

Investors will wait to see what the Fed has to say — if anything — about the credit worries that have the financial markets on a razor's edge.

The troubles in the mortgage market, and the tightening of credit, have raised the risk of both a financial crisis and an economic slowdown. That doesn't mean a crisis or a slowdown will occur, but it does mean this adjustment to tougher and more historically normal lending standards has the potential to become a full-blown credit crunch in which even good risks can't get credit. For an economy that runs on credit, that would be very damaging.

The stock market's extreme volatility in the last couple of weeks reflects investors' conflicting views of the likely outcome: The bulls think the economy has enough going for the market to weather the storm, while the bears think the economy will probably succumb to recession.

So, how does the Fed play in all this?

Fed policy has been "on hold." At the last five meetings, policymakers have left the key Fed funds interest rate unchanged at 5.25 percent, saying any change in stance would be driven by "incoming information."

But the Fed let it be known it was more worried about the risk of inflation than the risk of slow economic growth.

Many economists think the mortgage mess has changed the balance of risks, and the greater threat to the economy now is not inflation, but a downturn resulting from tight credit.

It's hard to find anyone who thinks the Fed will ride to the market's rescue with a rate cut. That would be premature, given the evidence of still-solid growth.

As political economist Tom Gallagher of ISI put it, "The Fed does not want to send a message that it's going to bail out a situation created by irresponsible practices."

But it is the Fed's job to help maintain public confidence in the markets, which has been battered by recent events.

Economist Tony Crescenzi at Miller Tabak says, "The markets don't need a rate cut, but they do need a confidence boost," and if the Fed fails to acknowledge the troubles in the credit market, it will appear "removed from reality."

If the markets believe the Fed is either ignorant or indifferent to its concerns, that could ignite a big sell-off.

Put it all together and the still-newish Fed chairman Ben Bernanke faces his first significant test. As Gallagher says, "You define your legacy by how you respond to a crisis," and Bernanke is looking down the barrel of his first.