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Desperado

“Central bankers alone cannot solve the world’s economic problems.”

Of all the things Ben Bernanke said in his speech at Jackson Hole Friday, that is the only one with which I am prepared to totally agree. The speech was widely anticipated and the initial reaction was underwhelming to say the least. Stocks sold off immediately upon release of the text of the speech with the Dow dropping roughly 120 points off the higher open. Whether it was Bernanke’s delivery or mere reconsideration, the market turned around and finished the day up 165 points. The market still finished down on the week; you know sentiment is negative when just reducing the losses feels like a victory.

I don’t know what all the other investors heard as Bernanke delivered his speech that convinced them to do some buying but all I could think of as I watched him and the other city slickers out in cowboy country were the lyrics to an Eagles tune from long ago:

Desperado, why don’t you come to your senses
You’ve been out ridin’ fences,
for so long – now.
Ohh you’re a hard one.
I know that you’ve got your reasons.
These things that are pleasin’you
Can hurt you somehow.

Frankly I’m not sure what anyone was expecting to hear but there was absolutely nothing new. Bernanke told us the economy was worse than he and the rest of the Fed expected and that despite that track record we should trust him that things will get better by next year. But just in case their current forecast turns out to be as accurate as the last one, he laid out four potential policy options now that interest rates are basically pegged to zero:

  1. Expand the balance sheet further by purchasing more Treasuries (or presumably something else if that doesn’t have the desired effect). This didn’t seem to have any lasting effect here in the US last time but the Asian countries with currencies tied to the dollar are quite happy with the effects, thank you very much.
  2. Somehow change the language of the FOMC statements to convince the market that “extended period” means even longer than already assumed. With the market currently anticipating a Fed tightening sometime after the end of the Mayan calendar, I’m not sure what that could possibly accomplish but the linguistic gymnastics alone would be interesting.
  3. Reduce the interest rate paid to banks for holding excess reserves at the Fed. Given that this was likely a huge mistake when it was implemented in August of 2008 this surely wouldn’t hurt but, like Bernanke, I don’t think it would do much good either. Losing that quarter of a % from the Fed doesn’t seem likely to send banks out on a lending spree.
  4. Raise the inflation target to a higher number. Even Bernanke isn’t buying this option. I find it hard to believe that there are still people who think that targeting the CPI is a good way to conduct monetary policy given its abject failure to date but if there are such people do they really believe that the Fed’s big mistake was to target too low a rate? Really? How big would the  housing bubble have gotten if the Fed was aiming for a 5% CPI inflation rate over the last decade instead of 2%? $140 oil wasn’t high enough for you? $1200 gold? $1.60 for a Euro? Damn….

If Bernanke accomplished anything in the speech it was to establish the ground rules for the Bernanke put. While he did say that no formal set of conditions had been established which would trigger further Fed action, he did, in what can only be interpreted as a shot across the bow of the more hawkish members of the FOMC, say that “the Federal Reserve will be vigilant and proactive in addressing significant further disinflation”. If the Fed’s target is 2% core inflation and it is now approaching 1%, that would seem to be the equivalent of drawing a line in the sand at 1% and saying, no further. The market reaction to the speech would seem to support that conclusion. Stocks and commodities rallied while bonds sold off. The TIPs market showed an increase in inflation expectations. Whether that lasts or not is questionable but at least for the day, Bernanke appears to have convinced the market of his determination to put a floor under the US inflation rate.

The Fed’s determination to prevent things from getting cheaper is a policy that defies logic. If the Keynesians are to be believed the problem with the US economy is a lack of aggregate demand which they intend to solve by making sure prices continue to rise. If you want to sell a larger quantity of stuff wouldn’t it make more sense to let the price fall? Oh wait, that can’t be right because the US government has done everything in its power to keep house prices from falling and that’s working like a charm.

The Fed can raise the rate of inflation as measured by the CPI and that will accomplish….what exactly? The theory is that it will reduce the real cost of hiring and reduce the unemployment rate. That might happen in some strange world where only labor prices are affected by monetary policy but not here on planet earth. If the Fed is successful the result will be a lower value for the dollar, higher commodity prices, higher interest rates and potentially higher consumer prices. One would be hard pressed to find a US economy based set of winners in that scenario. Exporters? Only if they don’t import any of their inputs. Miners? Last I checked gold mining required quite a bit of energy that we’ll have to continue importing at a higher price. Retailers? Higher dollar prices for consumer goods imports will mean either lower profits or lower volumes. Higher interest rates would be nice for savers but not if inflation is also higher. And how will higher interest rates help to reduce that still hefty inventory of houses out there?

Even Bernanke acknowledges that this inflation policy may not have the desired effect:

I believe that additional purchases of longer-term securities, should the FOMC choose to undertake them, would be effective in further easing financial conditions. However, the expected benefits of additional stimulus from further expanding the Fed’s balance sheet would have to be weighed against potential risks and costs. One risk of further balance sheet expansion arises from the fact that, lacking much experience with this option, we do not have very precise knowledge of the quantitative effect of changes in our holdings on financial conditions. In particular, the impact of securities purchases may depend to some extent on the state of financial markets and the economy; for example, such purchases seem likely to have their largest effects during periods of economic and financial stress, when markets are less liquid and term premiums are unusually high. The possibility that securities purchases would be most effective at times when they are most needed can be viewed as a positive feature of this tool. However, uncertainty about the quantitative effect of securities purchases increases the difficulty of calibrating and communicating policy responses.

When Bernanke and Co. started buying MBS, Agency and Treasury bonds in March 2009 there was a wide spread between Treasury and corporate yields. The Fed’s buying narrowed that spread by forcing the sellers to go out on the risk curve to try and maintain yield. That condition no longer exists though and if a future Fed QE program is successful it would push Treasury yields higher. If it doesn’t, the policy would by definition be a failure since the goal is to raise inflation expectations. It seems unlikely that higher corporate bond yields would assist in economic recovery.

As Bernanke said at the start of his speech, central banks cannot solve the world’s economic problems. It would be nice if our monetary desperadoes would come to their senses and stop adding to our problems though. Inflation isn’t the answer.

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