The Fed's Dr No refuses to come to Wall Street's rescue

Cool, calm and collected, Ben Bernanke, the Federal Reserve chairman, is driving Wall Street batty. When traders scream about a recessionary "credit crunch", the former professor acknowledges their concerns but predicts continued economic growth. When they plead for easier money, Bernanke and fellow rate-setters firmly hold the line.

"Scandalous," sputtered one North Carolina market strategist. Jim Cramer, the TV stockpicker, nearly melted in a pool of his own sweat on a recent programme, saying Bernanke had to flood the system with money to stop financial Armageddon. Shouted Cramer: "He has no idea how bad it is out there!"

The Street may be dismayed by Bernanke's sangfroid, but it shouldn't be surprised. This is exactly the kind of policy he has spent his entire career arguing for. At Princeton University, where he taught from 1985 to 2002, he said central bankers should avoid getting caught up in the gyrations of the financial markets and focus instead on measures of the real economy, such as growth and inflation.

The Fed should set a target rate for inflation and then steer monetary policy to hit that target – an approach that would change central bankers from financial demigods into something more like engineers.

Bernanke hasn't talked about inflation-targeting much since he became Fed chairman in February 2006, but the spirit of the approach was evident on 7 August when the Federal Open Market Committee announced it was leaving the federal funds rate unchanged at 5.25 per cent. Nodding just slightly to concerns about a credit crunch, the committee said: "Credit conditions have become tighter for some households and businesses, and the housing correction is ongoing." But it went on: "Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters." The committee even said it continues to regard inflation as a bigger risk than an economic slowdown.

The market's craziness is a perfect test case for Bernanke's circumspect approach because there's no evidence so far of a systemic crisis that would require him to abandon his theories and open the monetary floodgates. Yes, stock and junk bond prices have fallen, the sub-prime mortgage market is in dire straits, and a few Wall Street firms, including Bear Stearns, have taken a hit. But elsewhere, contagion is more of a future worry than a present-day reality.

Bernanke's approach recognises that the Fed can't be all things to all people. If it lowered rates to rescue sub-prime borrowers and their lenders, it would raise the risk of excessive borrowing and speculation in other sectors, possibly causing higher inflation and a stock bubble.

He is supported by many of his fellow academic economists. Among the most prominent is Allan Meltzer, a monetary economist at Carnegie Mellon University, who is writing a history of the Fed. "The people on Wall Street are making a lot of noise because they don't like to lose money," he says. "But it would be a huge mistake to change policy to rescue a bunch of people who made stupid mistakes." In fact, argues Meltzer, speculator losses could clean out the financial markets and make them healthier. "Capitalism without failure is like religion without sin," Meltzer says. "It doesn't work."

Wall Streeters, with their seven- and eight-figure pay, are hardly sympathetic figures. Unfortunately for millions of sub-prime borrowers, they too are directly under the Fed's interest-rate hammer. Strangely enough, they might be better off if the sub-prime problems did spill over to the rest of the economy, because then the Fed would be forced to cut rates. As it is, sub-prime borrowers are bearing the brunt of the Fed's inflation-fighting campaign. In fact, the strongest economic argument against Bernanke's stand is that it harms the poor and middle class when inflation is actually well in hand. The Fed's own preferred measure, the price index for personal consumption expenditures excluding food and energy, rose just 1.9 per cent in the year ended June 2007.

But as long as inflation threatens to go above the Fed's threshold, Bernanke believes his top priority is to keep it down – even if that makes some people unhappy. Clearly, this is one soft-spoken professor who knows how to say no.