Markets Want Bernanke to Detail an Exit Strategy

July 20, 2009

Fed Chairman Bernanke delivers his semi-annual Humphrey-Hawkins testmony to the House on Tuesday and the Senate on Wednesday.  At the last H-H testimony in February, he spoke about extraordinary economic weakness.  Quantitative easing by the Fed had already begun.  Although the start of a recovery might was deemed possible before end-2009, a full recovery was not anticipated for 2-3 years ,and even that delay was contingent upon the eventual success of macroeconomic support.

Recovery in the U.S. and global economies seems closer at hand as Bernanke prepares for this month’s testimony.  Since February 24th, the Nasdaq, S&P 500, and DOW have risen 31.6%, 22.3%, and 19.6%.  If these gains, which still leave equity prices far short of levels last September, not to mention highs in October 2007, were to evaporate, so would hopes of recovery.  Also since the last H-H testimony, the yield on 10-year Treasury bonds is up 85 basis points, and the dollar is narrowly mixed with a 2.0% gain against the euro but a 1.7% drop versus the yen.  Oil prices have shot up 59%, and gold is actually 1.5% softer although in elevated historic territory above $900.

Bernanke’s assignment this week will be to reassure the public and markets that officials will know how to identify the right time to begin absorbing liquidity, have the will and political cover to end quantitative easing in a way that neither aborts recovery nor fuels inflation, and that a plan with appropriate tools exist to carry out the task at just the right pace. This is Bernanke’s priority not because the time to exit QE has arrived but because that is what the Chairman’s audience wants to hear.  The Financial Times lead editorial today talks about jittery markets, whose unease will hopefully be allayed by a credible explanation from the Chairman.  I submit that nothing Bernanke says will accomplish that result.  The Fed’s critics will keep hammering away that a great inflation is going to result from the combination of a soaring public debt and a humongous Fed balance sheet.  Only the near-term reversal of those two excesses, which isn’t going to happen, will stop the doubters, and whatever Bernanke says will be forgotten soon, drowned in a sea of nay-saying.

The Greek chorus was heard in the 1930’s and during Japan’s lost decades.  Among the fiercest opponents of Japanese quantitative easing were several members of the Bank of Japan’s own Policy Board.  A review of the chronology of the Japanese experience can be found in a a December 18, 2008 posting on this weblog.  Unfortunately, there are not many good precedents to gain guidance for the contemporary economic situation.  But the two obvious ones, the Great Depression and Japan in the last two decades, suggest that the greater risk lies in the direction of too little economic activity, a widening deficiency of actual resource utilization versus full employment, and price deflation.  I worry that the U.S. economy will not tolerate a return of the Fed funds rate to 4-5% without slipping back into recession, and that a failure to normalize interest rates will result in the unacceptable choice of a new asset bubble.

Hopefully, Bernanke will be asked or in any case clarify if the present loose stance, consisting of near-zero interest rates and quantitative injections of excess reserves, will be reversed sequentially or simultaneously.  The Fed arrived at its present position by first cutting rates and only then moving on to a quantitative policy approach.  That was the chronology of Japan’s experience with QE as well, and Bank of Japan officials eventually tightened by reversing that sequence, that is first reabsorbing excess liquidity and then attempting to raise its short-term rate target. There have been hints in the press, that Bernanke’s team does not intend to be constrained by a sequential approach.

A final thought concerns the politicization of this particular testimony, which has two dimensions.  One possible corruption of the testimony relates to the expiration of Bernanke’s four-year term as Chairman at end-January.  In a sense, Bernanke is auditioning for a second term.  America no longer has a most-trusted person, but the substance and style of the testimony, plus the reaction of the market and others to it, will be scrutinized to see if a second term has chairman has been earned.  Greenspan was named to succeed Volcker just 2-1/2 months before the latter’s term expired, while Bush nominated Bernanke three months before Greenspan’s term was to end.  The proposed enhancement of the Fed’s regulatory powers has produced a backlash from some members of congress and parts of the general public.  Suggestions of subjecting monetary policy and the Fed balance sheet to an outside audit pose a direct challenge to a central bank’s most priceless commodity, which is independence from elected officials.  As Bernanke chooses his words and tone, the preservation of the central bank’s independence will be a factor that he reluctantly will need to consider.  Let the games begin.

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



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