BERNANKE ON INTEREST RATES AND CREATING BUBBLES:


It’s the cost of these policies and one that we take very seriously. We look at these possible mis-pricings and we ask ourselves are they in fact mis-pricings, how large are they, and if they are mis-pricings, what is the vulnerability.”

I ask you what the alternative is – interest rates are low for a good reason. But if in fact we come to the conclusion that the costs of these pricings are sufficient then obviously we have to take that into account. (Emphasis added)

There has been a lot of commentary the last few days about Ben Bernanke’s testimony before Congress last week, most of it concentrated on his comment that “my inflation record is the best of any Federal Reserve chairman in the postwar period.” I won’t waste your time debunking that one when my friend John Tamny has already done such a fine job but I do want to offer my two cents on the comment above. This is the first time to my knowledge that Bernanke has acknowledged the Fed’s role in creating bubbles. He doesn’t explicitly say that he was responsible for the housing bubble but if you believe we had one,  it is hard to see how this isn’t an admission of guilt. If bubbles are a cost of low interest rate policies today I don’t see how logically he could claim they weren’t yesterday.

I actually don’t like the term bubble because it implies that the “mis-pricings” in the market are just a result of irrational behavior on the part of individual market participants. While certainly some investors do act irrationally at times, mass delusions of the sort that drove stocks to nose bleed valuations in the late 90s or house prices to similar heights in the 00s do not happen in a vacuum. Indeed the initial rationale for buying stocks in 1995 or a house in 2002 was sound. Buying corporate equity in 1995 amidst the greatest productivity enhancement in a generation made a lot of sense. Likewise, buying real estate, commodities or other hard assets in 2002 amidst a currency devaluation was an equally rational investment decision. In both cases however, Fed and Treasury policies combined to distort market prices to such a degree that rational decision making was next to impossible. That or someone spiked the water supply with psychotropic drugs that made it rational to think house prices could never fall.

The admission that bubbles are a potential cost of current monetary policy raises some interesting questions. If Bernanke is aware of this cost, and considering the damage done by the bursting of the last two bubbles, why in the world is he continuing to pursue these policies? He seems to answer that question in the second quote – he doesn’t know what else to do. In his view, he has no choice but to pursue these policies – there are no alternatives. He is pursuing policies that he acknowledges cause “mis-pricings” simply because he can’t fathom that the proper answer might well be to do nothing. Having caused serious problems by distorting prices in the past he believes that he has no choice but to continue distorting prices in the present and the future. I don’t know about you but that is more than a bit scary to me.

Bernanke appears to believe that he and others at the Fed can identify when assets are “mis-priced” and to what degree. Having missed the internet bubble and the housing bubble we are supposed to now believe that the Fed can identify mis-pricings in real time, prevent them from getting out of hand and deflate them without damage to the economy. Really? What in their track record suggests this could possibly be true? Is there anything that suggests the previous “mis-pricings” produced benefits that would have been durable if the Fed had noticed them and stopped them before they got out of hand? I certainly can’t think of any and if that is true, what is the benefit of continuing to pursue these policies today?

As investors we are forced to ask ourselves some difficult questions too. Can we be certain that we are any better at identifying these “mis-pricings” than the Fed? Can we recognize a bubble in real time and take action to protect ourselves from its inevitable bursting? Are all prices in the markets distorted equally or are some markets more affected than others? Are we in a bubble now? If so, what asset classes? If so, how will we know when it has peaked and will we have time to get out of the affected market before incurring large losses? If not, how will we know when we are? Will we be able to resist participating in the bubble with everyone else? If not, will we be able to identify the trigger that causes its bursting? Will there be a trigger? Or will it just collapse of its own accord?

Investing today requires a large dose of humility. Anyone who knew me in 1999 knows that I did not participate in the last stage of the internet bubble. In fact, 1999 was one of the worst years of my investing career because I refused to drink the kool aid and learned through experience that trying to short a bubble is a painful and lonely experience. Anyone who knew me in 2006 knows that I also recognized the real estate bubble for what it was. And yet I must also admit that even while recognizing the existence of the bubble, I failed to recognize the magnitude of the consequences. I did not anticipate the depth of the 2008 sell off and I paid a price for that even if it wasn’t as high a price as a lot of other investors. So, I will not tell you here that I have the ability to completely anticipate all the consequences of today’s misguided Fed policies. Anyone who tells you they can is either deluded or lying or trying to sell you something.

What I can tell you with conviction is that I know there will be consequences for present Fed policy and that we will be vigilant in trying to avoid them. I don’t see anything that is of the magnitude of the internet or housing bubbles right now but there are asset classes that I think are overpriced and not worthy of our attention or investment dollars (junk bonds come to mind). I would also warn that the consequences of bad monetary policy are not confined to the US. The effects of Fed policy are felt outside the US and the Fed is also not the only central bank actively distorting market prices. If I had to place a bet today on the location of the next crisis my wager would be on emerging markets and specifically Asia. Japan has introduced a potentially destabilizing policy to an already volatile mix and there will undoubtedly be unintended consequences. That doesn’t mean that Japan itself will be the next victim of activist monetary policy but it might well be the cause.

For now, US economic policy is not improving although we did get some decent data last week. I am skeptical that it is sustainable but I’ll take the data as it comes in while keeping in mind that our only economic plan at this point appears to be for the Fed to create another bubble and hope it ends better than the last two. It isn’t much of a plan but right now it is all we have. In Bernanke We Trust.

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@4kb.d43.myftpupload.com or   786-249-3773.

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