Chairman Bernanke's Debut
Although I believe that the February economic data will be considerably softer than those of January, as things now stand, new Fed Chairman Bernanke gave market participants no reason to believe that the FOMC was ready to declare a cease fire with respect to fed funds rate increases. The following passage from Bernanke's prepared testimony to the House Committee on Financial Services today speaks to this point:
"Gauging the economy's sustainable potential is difficult, and the Federal Reserve will keep a close eye on all the relevant evidence and be flexible in making those judgments. Nevertheless, the risk exists that, with aggregate demand exhibiting considerable momentum, output could overshoot its sustainable path, leading ultimately--in the absence of countervailing monetary policy action--to further upward pressure on inflation. In these circumstances, the FOMC judged that some further firming of monetary policy may be necessary, an as sessment with which I concur."
Although a 25 basis point hike in the fed funds rate looks to be a fait accompli, further rate increases are much less certain and are more dependent on the incoming economic data. To wit:
"Although the outlook contains significant uncertainties, it is clear that substantial progress has been made in removing monetary policy accommodation. As a consequence, in coming quarters the FOMC will have to make ongoing, provisional judgments about the risks to both inflation and growth, and monetary policy actions will be increasingly dependent on incoming data."
I find this "data dependent" guide to policy somewhat curious given Bernanke's Q&A comment that monetary policy actions work with a lag of up to 18 months. If the Fed is currently making policy based upon incoming data and the full effects of past policy actions have not been made, how does the Fed know that the next set of data might not paint a different economic picture? To be specific, January economic data have been strong and it is likely that real GDP growth for the first quarter will be in excess of 4%. But given that the Fed will have increased the funds rate by a cumulative 100 basis points from November 1 through March 28 and given the lagged effects of past interest rate increases, how would the Fed know whether the March 28 increase was necessary just because first-quarter economic momentum was strong?
A look back at recent history shows what a misleading leading indicator current economic momentum can be. As the Chart 1 below shows, quarter-to-quarter annualized real GDP growth in Q2:2000 was a strong 6.4%. However, in the very next quarter, real GDP contracted. Moreover, real GDP growth did not get back to 3% or above until Q2:2003 - three years later!
Also notice in the chart above that the spread between the 10-year Treasury security yield and the fed funds rate was minus 10 basis points in Q2:2000, the quarter in which real GDP growth was 6.4%. Why do I mention this spread within the context of discussing Bernanke's House testimony? Because Bernanke commented today that the current flat yield curve did not portend an economic slowdown. I imagine it would have been easy to reach that same conclusion back in the second quarter of 2000 when real GDP growth was soaring and the yield curve was inverting. Accepting the negative message of leading indicators in the face of the positive message of coincident indicators is always a dilemma.
Chairman Bernanke's comments today about the yield curve are somewhat at odds with other comments he made today and with those he made in March 2005. In today's comments, Bernanke reiterated his view that the low level of nominal and real U.S. bond yield was due, in part, to the excess supply of global saving relative to global investment opportunities. My interpretation of this is that the equilibrium structure of interest rates is lower than what it has been in the past 30 years or so. So, despite the low level of bond yields - in both nominal and real terms - it would be entirely consistent theoretically for a flat yield curve in the environment described by Bernanke today to be signaling slower real economic growth ahead. Back in March 2005, when Bernanke had introduced the concept of an excess supply of global saving, he remarked in a speech given in Chicago:
"The funds rate will have reached an appropriate and sustainable level when, first, the outlook is consistent with the Committee's economic goals and, second, the slope of the term structure of interest rates is approximately normal, as best as can be determined. With this definition in mind, one can search for indications of where the "neutral" funds rate is likely to be at a given point in time. For example, the fact that far future short-term interest rates have recently declined fairly significantly suggests that, in the view of the markets at least, the neutral funds rate may be somewhat lower today than it was in the past." (http://www.federalreserve.gov/boarddocs/speeches/2005/20050308/default.htm)
Does Fed Chairman Bernanke now believe that an inverted yield curve is "approximately normal" in a fiat-money financial system?
Bernanke sees the biggest risk to continued potential economic growth coming from the housing market:
"For example, a number of indicators point to a slowing in the housing market. Some cooling of the housing market is to be expected and would not be inconsistent with continued solid growth of overall economic activity. However, given the substantial gains in house prices and the high levels of home construction activity over the past several years, prices and construction could decelerate more rapidly than currently seems likely. Slower growth in home equity, in turn, might lead households to boost their saving and trim their spending relative to current income by more than is now anticipated."
"Thus, at this point, a leveling out or a modest softening of housing activity seems more likely than a sharp contraction, although significant uncertainty attends the outlook for home prices and construction."
With housing affordability at its lowest level since 1991, with the bank regulators about to issue tougher lending guidelines for issuing of "nontraditional" mortgages and with Bernanke's obvious concern about the ripple effects of a sharp contraction in housing-related activity, I would think that the Fed would not want to raise the funds rate much more unless inflation or inflation expectations were to raise its ugly heads.
Texas Representative Ron Paul asked Bernanke if the Fed would reconsider publishing the M3 money supply after the planned cessation in March inasmuch as inflation is a monetary phenomenon. Bernanke responded that the reason for the planned cessation is that the Fed staff had not found M3 as a useful indicator of monetary policy. Therefore, in order to reduce the reporting costs to financial institutions, The Fed had decided to drop the calculation and publication of M3. Bernanke did say, however, that if Congress found M3 useful, the Fed would reconsider its decision. How can Congress or non-Fed analysts assess the usefulness of M3 if the data will no longer be available? As an aside, Bernanke did say that the M2 money supply was useful in assessing the thrust of monetary policy. But I guess, like the flat yield curve, it's different this time. Chart 2 shows that year-over-year growth in the real M2 money supply decelerated to 1.0% in Q4:2005. This feeble real M2 growth is well below what it was in the quarters near the onset of the 2001 recession.
So, I guess for all the talk about a more transparent Bernanke Fed, we still don't have a clue as to what leading indicators the Fed uses to guide its policy decisions other than the latest set of economic reports. The more things change, the more they stay the same.
Below is a table of the FOMC's economic forecasts. The FOMC's central-tendency forecast for core inflation is "about" 2% Q4/Q4 in 2006. This is not so much a forecast as a goal. The FOMC's central-tendency forecast for 2006 real GDP growth of "about"
3-1/2% seems a bit optimistic inasmuch as growth was only 3.1% in 2005 and that the full effects of 2005 interest rate increases have yet to be felt, not to mentio n any 2006 rate increases.
Economic projections of Federal Reserve Govenors and Reserve Bank presidents
for 2006 and 2007
Lastly, I was disappointed in Bernanke's responses to the congressmen's and congresswomen's queries about issues outside the realm of monetary policy. Bernanke had indicated in his confirmation testimony that he would try to confine his comments to monetary policy issues. And to some degree, he did say less about other issues in his prepared testimony and the Q&A today than was the practice of his predecessor. Moreover, Bernanke cannot dictate to Congress the questions to be asked of him. But rather than even giving cursory answers to questions about income inequality, taxation and the minimum wage, Fed Chairman Bernanke could make it clear that his responsibility is for managing monetary policy. If Congress wants to exercise its oversight responsibilities with regard to monetary policy, hearings such as today's is one such opportunity to do so. If Congress wants to know how best to address income inequality, then it should call expert witnesses in this area. If the Fed wants to maintain its political independence, then its chairman should make it clear to Congress that he or she will not comment on issues other than those directly related to the conduct of monetary policy. Isn't the issue of fixing one of the most important prices in the world, the price of short-term U.S. credit, difficult enough to keep Bernanke & Co. busy without having to be an expert on everything else?