Bernanke: Central Bankers Bob the Builder?
First, the good news about Bernanke's nomination for a second term as head of the Federal Reserve (Fed): we know what we are getting and may be able to prepare for the risks his continued leadership may pose to inflation and the dollar. The bad news: more of the same.
Let's examine the good news first. You see, until recently banking had been a relatively simple business, as exemplified by the 3-6-3 rule: pay your depositors 3%; lend to them at 6%; and be off to the golf course by 3pm. This model began to fall apart in the 1970s for most corporate banks, but what hasn't changed is that central bankers typically like to keep things as simple as possible by moving levers such as interest rates and money supply. One reason central bankers like to keep things simple is because they are (as tough as it might be for some to admit) pawns like the rest of us in a dynamic economy. At times, they may try to intervene in the markets to assert their power, but in the long-run such activity may be akin to sipping water from the ocean using a straw.
Central bankers do have the power to pave the way for an economy. However, they traditionally do not have the power to decide where and how the asphalt will be laid; central banks control how much asphalt (currency) to produce, but producing asphalt and laying a road are completely different skill sets, something the Fed is currently learning the hard way. Incidentally, judging by Bernanke's feverish foray into currency production and allocation, we wouldn't be surprised if Bernanke believes himself to be central bankers' equivalent of Bob the Builder.
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In all seriousness though, we believe central banking is more predictable than it may seem. And Ben Bernanke is more predictable than most. It appears to us that he is applying what he has written in his books about the Great Depression to today's markets. A plausible alternative to Bernanke's nomination would have been Lawrence Summers, Director of the White House's National Economic Council. We have previously referred to Mr. Summers, known for his, at times, abrasive style, as a "loose cannon"; this is not intended as a personal criticism, but a reflection of a character trait that is traditionally not desirable in a central banker, as unpredictability can raise the cost of borrowing for everyone.
With Bernanke, in contrast, we have a pretty good understanding of the policies we are likely to get. But before we rejoice over predictability, let's put some light on the dark side of transparency in the policies pursued. Over the long run, if central bankers pursue their policies credibly, they may be able to control inflation. That's why a lot of attention is paid to what central bankers say and do. However, there are a couple of myths about inflation. The greatest myth out there may be that inflation is primarily a function of the slack in the economy, or what economists refer to as the output gap. It's a fairy tale promoted by Bernanke, amongst others. In our humble opinion, and our understanding of the facts, inflationary expectations, not the output gap, is what drives inflation. If people believe there may be inflation, they will ask for higher wages, try to raise prices, causing inflation.
From our perspective, the best way for a central bank to keep inflationary expectations low is through the pursuit of sound monetary policy; a policy that focuses on price stability. Most central banks have the pursuit of price stability as their primary, if not only, goal. The Fed, in contrast, also has maximum sustainable employment as a secondary goal. A key reason why other central banks, such as the European Central Bank (ECB), do not state employment as a goal is because economists generally believe that an environment that fosters price stability is the most appropriate way to achieve maximum sustainable growth, and hence, maximum sustainable employment.
Why would Bernanke then keep pounding the table that inflation isn't an issue because there is such slack in the economy? Because in the absence of sound monetary policy, a central bank might get away with a few transgressions as long as it can remain credible that it hasn't taken its eyes off inflation. In our humble opinion, that is what Bernanke's focus on transparency is all about: managing expectations.
First, the good news about Bernanke's nomination for a second term as head of the Federal Reserve (Fed): we know what we are getting and may be able to prepare for the risks his continued leadership may pose to inflation and the dollar.
Here's why expectations management is so important. Until 2007, the Fed would only need to utter a few words and the markets would move: the cheapest and most effective monetary policy is one where no money is printed, no interest rate targets are changed, but where a few words help guide the markets. In early 2008, volatility in the markets started to explode, setting the stage for what we now call the bursting of the credit bubble. The Fed needed to engage in an emergency rate cut of 0.75% in January 2008, lowering interest rates to 3 ½% at the time: talk was not good enough anymore, the Fed needed to act. Since then, the Fed has printed well over $1 trillion dollars to pave the way for an economic recovery (economists talk about increasing the Fed's balance sheet which can be seen as the equivalent of a virtual printing press). In each phase, Fed policy has become more expensive to implement, as credibility in the Fed appears to have eroded.
In our assessment, there have been two common threads in Ben Bernanke's tenure: he has followed his own textbook approach to handling the financial crisis; and he has completely underestimated the political implications of the policies pursued. In many ways the term ivory tower academic comes to mind. The relevance here is that many policies Bernanke has engaged in have veered off the path of what central banking is all about: rather than supplying the asphalt, he is patching up the roads. And if Bernanke were truly patching roads with freshly produced asphalt, Bob the Builder would quite likely be rather unhappy that someone is stepping on his turf. Bob the Builder is the construction expert; Ben ought only be the supplier of raw materials. Translated to monetary policy, the Fed's credit easing programs, those programs providing specific credit to, say, the mortgage market, are fiscal, not monetary policy. By engaging in fiscal policy, the Fed is inviting political scrutiny. If the Fed were to focus on traditional monetary policy, the setting of interest rates or targeting money supply, the private sector - subject to guidance from laws and regulations passed by Congress - decides where credit is allocated. But Bernanke seems to want his policies to be more targeted; we are afraid that he may achieve the opposite: the more political scrutiny he invites, the less effective policies may become as the credibility of the Fed may be further eroded.
Lobbying for the Fed to become a more active super-regulator further exacerbates the political meddling in the Fed's affairs. Similarly, the massive hiring that the Fed has been engaged in suggests that all the new programs the Fed has implemented may be around for some time.
Not too surprisingly, we don't think the Fed's announced exit strategy is very credible. There are two components to our doubts: some of activities the Fed has been engaged in may be far more difficult to unwind (or "neutralize") than they would have us believe; and secondly, we do not believe the economic recovery will be sustainable enough to allow for a decisive exit of the credit easing programs. We cannot imagine the Fed raising interest rates as high as 20 percent the way former Fed Chairman Paul Volcker did in the early 1980s to weed out inflation - there is simply too much leverage in the consumer today.
The conclusion we draw from the Fed's talk about exit strategies and focus on inflation is mostly just that: talk. While we understand why the Fed is talking - to manage inflationary expectations - we believe the Fed may be playing with fire at our expense.
Indeed, following Bernanke's textbook, our interpretation is that the Fed may want to have inflation; and to get there, he may want a cheaper dollar, a substantially cheaper dollar. Bernanke has repeatedly stressed how going off the gold standard during the Great Depression jump started economic activity by allowing the price level to rise (read inflation). Fast-forward to today and think about all those homeowners "underwater" with their mortgages. We could allow those who cannot afford their homes to downsize, i.e. allowing market prices to clear by allowing foreclosures and bankruptcies, amongst others; however, that option seems to be political suicide. An alternative is to induce inflation, allowing the price level to rise; the Fed may not be able to control what prices will rise, but seems to be betting on home price inflation.
Looking at what at the Fed does, rather than what the Fed says, we believe it is actively working on a weaker dollar. In discussing the Fed's programs, the media seems to focus on the low mortgage rates and government bond yields that lower the cost of borrowing. The flip side of such activities, however, is that the securities the Fed buys, be they Treasury Bonds, Mortgage Backed Securities, or others, are intentionally overvalued as a result of the Fed's interventions. Why would a rational buyer be interested in these securities? We believe many of the Fed's programs replace, rather than encourage, private sector activity. It doesn't take a rocket scientist to make the connection to the dollar: foreigners may not be attracted to U.S. securities if they are not properly compensated for the risk they are taking. Indeed, it is not just foreigners we should be concerned about: from what we hear, U.S. institutions are increasingly hedging their U.S. dollar risk, something unheard of in a developed country in years past.
We manage the Merk Hard and Asian Currency Funds, no-load mutual funds seeking to protect against a decline in the dollar by investing in baskets of hard and Asian currencies, respectively. To learn more about the Funds, or to subscribe to our free newsletter, please visit www.merkfund.com.