Reaction to Bernanke

July 22, 2009

A drop in Treasury long-dated yields and further advance in U.S. equities suggests that Fed Chairman Bernanke managed to contain expected inflation and reassure investors and Congress that the Fed has the technical know-how to reverse its loose policy.  However, markets may also be reacting to his other message that the U.S. economy remains fragile amid only tentative evidence of stabilization.  The present loose stance will not be snugged for “an extended period,” and Bernanke is asking for public trust that he will know when and how to get that job done.

Major business newspapers had similar interpretations of the semi-annual testimony.  Coverage in today’s New York Times is entitled, “Seeing Perils Yet to Come, Fed Aims to Hold Down Rates.”  The Financial Times proclaims, “Bernanke outlines Fed’s exit strategy: Rates set to stay low for extended period,”  and the Wall Street Journal runs the following header: “Bernanke Says Fed Policies Are Sowing Recovery.”

The main reservations about Fed policy were pretty straightforward as this site indicated yesterday and were not exactly addressed by the Chairman.  Investor misgivings do not concern a lack of ways to reverse policy or doubts that the process could be handled quickly.  They rather boil down to whether monetary policy makers will, as the FT notes, get the “timing and pace of tightening” right.  I believe the speed of the policy reversal is more important than the timing of its onset.  Most criticism, as espoused in a skeptical Journal editorial today centers around a view that Fed officials will be too timid and overly subservient to political pressures from elected politicians.  The Journal reminds readers that Bernanke is lobbying for his own reappointment to another four-year term, but that issue should be settled by November, thus before anyone realistically thought tightening might be starting.

The Journal’s more compelling point is the unfortunate choice of the phrase “extended period,” which that paper points out was used in late 2003 (two years after GDP had stopped contracting) by Bernanke as one of the Fed’s governors to signal how much longer a cheap 1% Federal funds rate should be retained.  Bernanke’s instincts proved wrong then, and the Journal’s editors suspect they will be wrong again.  Typical of Fed-speak, “extended period” is a difficult expression to quantify, intended to convey a gestalt to the marketplace while leaving the central bank with plenty of flexibility to do whatever future conditions convince officials is the right course.  The Chairman did say that timing would be influenced especially by labor market conditions and other measures of productive resource slack.  The same thinking applied in 2003.  The jobless rate had only peaked in June of that year at 6.3% and had dipped merely to 6.1% in September and 5.7% at yearend.  After the prior recession, unemployment also crested (June 1992) more than a year after recession ended (March 1991) and initially slid very gradually by two-tenths through September and four-tenths through end-year.  The Journal urges policymakers to be guided by other factors like the dollar and commodity prices, which would represent a huge shift in policy guidance from anything tried recently.

A huge factor from my standpoint continues to go unexplored by officials and private analysts, which is whether the severe illness in America’s financial system and only quarter-baked solutions to rid root causes of the problem may result in a greatly reduced tolerance of the economy for rising and/or higher interest rates.  That is exactly what happened in Japan under fairly analogous circumstances.  The problem may not hinge on a bias of Fed officials to err systematically on the side of excessive inflation rather than deficient growth.  The impediment to raising interest rates may instead be the economy’s inability to handle the medicine.  In the best of times, growth ought to slow after policy tightens as such did to 0.9% at a seasonally adjusted annual rate in the first half of 1995 from 3.5% saar in 2H94 and 4.7% saar in 1H94, a period when the funds rate doubled to 6%.  If the banking system has only been cosmetically patched without changing the corrupting incentives that created the 2007-8 problems, it will not be well-prepared to handle the stress that aggressive Fed tightening will produce.

All three newspapers mentioned the backdrop of Congressional efforts to assert greater control over the central bank.  Ron Paul, the libertarian congressman from Texas and unsuccessful candidate for president, is the Fed’s fiercest critic, a modern-day Andrew Jackson who wants to close the institution down.  For the record, U.S. business cycles were particularly severe in the absence of a central bank between 1836 and 1913.  There were several financial busts and depressions. The impetus to establish the Fed came from the crises of 1893 and 1907.  Mis-managed monetary policy can do enormous damage and is widely blamed for the Great Depression.  The remedy lies in better understanding of macroeconomics and courageous central bankers to apply that knowledge.  Its axiomatic that central banking tends to be more competent when decision-making is separated from the influence of elected politicians.  An additional consideration in the United States that underscores the value of an independent Fed should be how best to preserve the dollar’s status as a prized reserve currency asset.  Eliminating the Fed would be one of the best ways to destroy confidence in U.S. money.

Copyright Larry Greenberg 2009.  All rights reserved.  No secondary distribution without express permission.

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