The Bernanke Era:
Some Thoughts on the New
Fed Chairman
John Mauldin
October 29, 2005
A Slower Muddle Through
Economy
A Very Clear Fed Speech
Stimulating Aggregate Demand
Detroit, New York and Dallas
The King is going. Long live
the King. We now know that Ben Bernanke will be the next Fed
Chairman. His approval by the Senate is as close to a lock as
you can get. This week we focus on Bernanke, and specifically
his most famous, and what I think one of the most important speeches
ever by a Fed governor. We will look at how policies might change,
the risks involved. Bernanke faces some very real challenges.
We should all wish him well.
First, let's look at who Bernanke
is: Dr. Ben Bernanke was the Chairman of the Department of Economics
at Princeton. He was the Director of the Monetary Economics Program
of the NBER (National Bureau of Economic Research) and the editor
of the American Economic Review. He co-authored a widely used
textbook on macroeconomics. He is obviously well-respected in
economic circles. He was appointed to the Board of Governors
for the Fed in 2002. He was appointed the Chairman of the President's
Council of Economic Advisors in June of this year.
I wrote and said at the time
this was probably a stepping stone to the Fed chairmanship. It
was a way for Bush to get to know him personally. Bush likes
to know his major appointments on a personal level, and this
is one of his most important appointments of his presidency.
It was unlikely to go to a stranger. Clearly, Bernanke passed
the personal presidential tests. By all accounts, Ben is well
liked by his peers as well. He is an economic insider, who is
as suited academically for the task as anyone.
It is unlikely we will see
many changes in Fed policy, at least his first year. Bernanke
has written at length that the Fed should set specific inflation
targets. Greenspan likes soft targets. But for all intents and
purposes, the Fed has had a target of 1-2% for the core rate.
Bernanke would not change that. Maybe, over a long time we get
to more explicit targets, but not next year.
Secondly, Bernanke has advocated
a more open Fed policy. I think we will see a more transparent
Fed, and this is a good thing.
But Greenspan does not hand
Bernanke an easy job. There are serious imbalances that will
have to be dealt with over the coming years. There is no housing
bubble, Bernanke tells us this week. Yet the markets and buyers
in certain cities will be the ultimate judge. Certainly, there
are signs the housing market is slowing. The number of housing
sales has been gradually slowing and the number of homes for
sale, especially in some overheated markets, is rising. The average
price paid for a home is dropping. As mortgage rates rise, this
will make housing less affordable. It also means that cash out
financing is going to be more difficult.
A Slower Muddle Through Economy
We see today that GDP for the
third quarter is estimated to be a very healthy 3.8%. Greenspan
is leaving while things look good. But Bill Gross suggests that
things might not look good for long. Writing this week:
"Typically an economic
slowdown occurs 18 months after the beginning of an upward move
in 5-year rates, and this cycle appears to be no exception with
industrial production and service-related indicators having peaked
nearly a year ago. We are due for what appears to be a 2%
or less GDP growth rate in 2006, a rate sure to stop the Fed
and to induce eventual ease at some point later in the year.
It will likely be Bernanke's first policy shift and an indicator
of his willingness to address the Fed's dual mandate of inflation
targeting and economic growth."
Such a slower growth is what
I have thought as well, as I think much of the rest of the decade
could be a Muddle Through Economy. (I hope I am wrong.) This
could cause some late nights in the Chairman's office. Martin
Wolf, writing an open letter to Bernanke in the Financial Times,
made the following points:
"You [Ben] will need to
react strongly to low probability, high cost dangers. You have
shown your willingness to do just this with your contributions,
in 2002, to the analysis of the risks of deflation. As important,
you will need to act as lender of last resort in times of financial
panic. The Greenspan Fed was outstanding in its response to such
crises, from the stock market crash of 1987 to the aftermath
of the Russian default of August 1998 and the terrorist attacks
of September 2001. Similar tests will lie ahead, if not more
so.
"Why do I write "if
not more so"? The answer is one you have identified in your
writings on the "global savings glut". We share the
view that the US has rightly been acting as spender and borrower
of last resort in the world economy. In seeking internal balance
- or the maximum level of employment consistent with stable inflation
- the Fed has had to offset the contractionary impact of the
net private and official capital inflows, now running at over
6 per cent of US gross domestic product. If the Fed had not taken
this action, the world would have been at risk of a deep recession,
if not of something even worse.
"The willingness of US
monetary and fiscal authorities to sustain demand in this way
has been highly desirable. But, at some point, probably on your
watch, there will be a correction. Most analyses suggest that
this will require a very large depreciation of the real exchange
rate, to shift output towards - and domestic demand away from
- tradeable goods and services. Such a depreciation would require
a big fall in the dollar and rise in domestic prices of tradeables.
It would also, almost certainly, entail a jump in long-term interest
rates.
"Managing this adjustment,
without either a deep US recession or an inflationary spiral,
would test even an Alan Greenspan. The Fed will need to be both
flexible and determined. It will probably have to endure unpopularity,
as well. Mr. Greenspan was lucky enough and clever enough to
be popular for much of the time. But good central bankers must
expect to be unpopular at least some of the time. This job is
as much a test of character as of intelligence. "
That sums up the problem facing
the Fed during the next slowdown/recession. If they fight a deep
recession (and they will!! see the comments on Bernanke's speech
below), which is by definition deflationary, they risk inflation.
It is an extremely difficult proposition. As I have said for
years, I think the best they can do is give us a slow growth
Muddle Through Economy, as we correct the imbalances.
If Bernanke can pull that off,
he should be treated with far more respect than Greenspan, who
never faced such a problem. Greenspan was Fed chair at the right
time. Not that he did not do a very good job, but now Bernanke
has to deal with the aftermath. Not an easy task. But I should
note, if we are in a Muddle Through, slow growth economy, no
one will be very happy. Bernanke will not be celebrated, I fear.
However, given the recent strength
of the economy, the Fed is going to continue to raise rates.
We will see 4.25% by the end of the year. Given that the Bernanke
speech which we will discuss in a moment is the famous "printing
press" speech, it is going to be hard for him not to raise
rates once more at the very least to establish himself as a worthy
opponent of inflation, assuming the economy does not soften that
much during this quarter. So, 4.5% is quite possible early in
the first quarter at the January Fed meeting. Will such a move
help precipitate the slowdown Gross predicts?
I think that we are probably
at the top of the inflationary cycle. For reasons outlined over
the past few years, I think the normal course of the world is
deflationary. That is the problem that we may be discussing if
the US enters into slowdown/recession. And that brings us to
Bernanke's speech. It is the one where he talks of printing presses
and helicopters dropping money, which is what most people focus
on. That is not the reason to pay attention, however. There are
some real clues as to Bernanke's mindset in this speech. Let's
look at it in detail.
I believe this was his first
major speech as a Fed governor. It was made to the Economist
Club in Washington on November 21, 2002. The economy was in the
doldrums, and there was a real concern about the possibility
of actual deflation coming to US shores. Dennis Gartman referred
back then to this speech as "... in our opinion the most
important speech on Federal Reserve and monetary policy since
the explanation emanating from the Plaza Accord a decade and
a half ago."
We will look at the particulars
in a few paragraphs, but we need to keep in mind this was not
a random speech. While Bernanke states that the views in this
speech are his own, for reasons I will go into later, I believe
this speech was indicative of the thinking of various members
of the Fed, and was given to make unambiguous the Fed's views
on deflation. The title of the speech is very straightforward:
Deflation: Making Sure "It" Doesn't Happen Here.
First and foremost, as Gartman
wrote, "Dr. Bernanke has made it clear that the Federal
Reserve Governors are painfully aware of the very severe problem
that a pervasive deflation would manifest upon the US economy
and the US society, and they are not prepared to allow that to
happen. They will do what they must in order to alleviate deflation,
including erring openly upon the side of inflation..."
On one level, this speech breaks
no new ground from that of the previous Federal Reserve white
paper on the causes of deflation in Japan, and what the US Fed
and other central banks could do to avoid deflation. I wrote
about that paper in the summer of 2002, stating that it was clear
to me, at least, that the Fed understood the nature of the problem
and was telling us they did not intend to see the US slip into
deflation. This is one reason I believe the speech is reflective
of Fed thinking, and not simply Bernanke's thoughts.
A Very Clear Fed Speech
The difference between that
paper and Bernanke's speech is two-fold. The paper was presented
in the framework of an academic exercise, and had no official
stamp of Fed governor approval. It could be viewed as theoretical,
although I and a number of other analysts did not see it that
way.
Secondly, this speech was actually
delivered in very clear, well written English. The average layman
could read and follow the thoughts. You can read the speech here.
First, let's go to the more
controversial parts of the speech. What are they (the Fed) willing
to do to avoid deflation? This is the part that has raised the
hackles of more than a few writers. I will quote:
"As I have mentioned,
some observers have concluded that when the central bank's policy
rate falls to zero--its practical minimum--monetary policy loses
its ability to further stimulate aggregate demand and the economy.
At a broad conceptual level, and in my view in practice as well,
this conclusion is clearly mistaken. Indeed, under a fiat (that
is, paper) money system, a government (in practice, the central
bank in cooperation with other agencies) should always be able
to generate increased nominal spending and inflation, even when
the short-term nominal interest rate is at zero.
"The conclusion that deflation
is always reversible under a fiat money system follows from basic
economic reasoning. A little parable may prove useful: Today
an ounce of gold sells for $300, more or less. Now suppose that
a modern alchemist solves his subject's oldest problem by finding
a way to produce unlimited amounts of new gold at essentially
no cost. Moreover, his invention is widely publicized and scientifically
verified, and he announces his intention to begin massive production
of gold within days. What would happen to the price of gold?
Presumably, the potentially unlimited supply of cheap gold would
cause the market price of gold to plummet. Indeed, if the market
for gold is to any degree efficient, the price of gold would
collapse immediately after the announcement of the invention,
before the alchemist had produced and marketed a single ounce
of yellow metal.
"What has this got to
do with monetary policy? Like gold, U.S. dollars have value only
to the extent that they are strictly limited in supply. But the
U.S. government has a technology, called a printing press
(or, today, its electronic equivalent), that allows it to produce
as many U.S. dollars as it wishes at essentially no cost. By
increasing the number of U.S. dollars in circulation, or even
by credibly threatening to do so, the U.S. government can also
reduce the value of a dollar in terms of goods and services,
which is equivalent to raising the prices in dollars of those
goods and services. We conclude that, under a paper-money system,
a determined government can always generate higher spending and
hence positive inflation. ... If we do fall into deflation, however,
we can take comfort that the logic of the printing press example
must assert itself, and sufficient injections of money will ultimately
always reverse a deflation."
Bernanke goes on to point out
that the Fed could also supply interest free loans to banks,
monetize foreign assets, buy government agency bonds, private
corporate assets or any number of things that could induce inflation.
Those words, taken out of context,
could be seen as rather extreme, confirming the worst fears about
central banks among certain groups and yet another reason to
buy gold. There may be reasons in this speech to want to add
a little gold to your portfolio, but these sentences are not
among them.
Let's look at what Bernanke
really said. First, he begins by telling us that he believes
the likelihood of deflation is remote. But, since it did happen
in Japan, and seems to be the cause of the current Japanese problems,
we cannot dismiss the possibility outright. Therefore, we need
to see what policies can be brought to bear upon the problem.
He then goes on to say that
the most important thing is to prevent deflation before it happens.
He says that a central bank should allow for some "cushion"
and should not target zero inflation, and speculates that this
is over 1%. Typically, central banks target inflation of 1-3%,
although this means that in normal times inflation is more likely
to rise above the acceptable target than fall below zero in poor
times.
Central banks can usually influence
this by raising and lowering interest rates. But what if the
Feds fund rates falls to zero? Not to worry, there are still
policy levers that can be pulled. Quoting Bernanke:
"So what then might the
Fed do if its target interest rate, the overnight federal funds
rate, fell to zero? One relatively straightforward extension
of current procedures would be to try to stimulate spending by
lowering rates further out along the Treasury term structure--that
is, rates on government bonds of longer maturities.....
"A more direct method,
which I personally prefer, would be for the Fed to begin announcing
explicit ceilings for yields on longer-maturity Treasury debt
(say, bonds maturing within the next two years). The Fed could
enforce these interest-rate ceilings by committing to make unlimited
purchases of securities up to two years from maturity at prices
consistent with the targeted yields. If this program were successful,
not only would yields on medium-term Treasury securities fall,
but (because of links operating through expectations of future
interest rates) yields on longer-term public and private debt
(such as mortgages) would likely fall as well.
"Lower rates over the
maturity spectrum of public and private securities should strengthen
aggregate demand in the usual ways and thus help to end deflation.
Of course, if operating in relatively short-dated Treasury
debt proved insufficient, the Fed could also attempt to cap yields
of Treasury securities at still longer maturities, say three
to six years."
He then proceeds to outline
what could be done if the economy falls into outright deflation
and uses the examples, and others, cited above. It seems clear
to me from the context that he is making an academic list of
potential policies the Fed could pursue if outright deflation
became a reality. He was not suggesting they be used, nor do
I believe he thinks we will ever get to the place where they
would be contemplated. He was simply pointing out the Fed can
fight deflation if it wants to.
With the above as background,
now we can begin to look at what I believe is the true import
of the speech. Bernanke clearly feels that the Fed can stimulate
demand in the economy. Read these sentences, noting my bold,
underlined words:
"...a central bank, either
alone or in cooperation with other parts of the government, retains
considerable power to expand aggregate demand and economic
activity even when its accustomed policy rate is at zero."
"The basic prescription
for preventing deflation is therefore straightforward, at least
in principle: Use monetary and fiscal policy as needed
to support aggregate spending..."
Again: "...some observers
have concluded that when the central bank's policy rate falls
to zero--its practical minimum--monetary policy loses its ability
to further stimulate aggregate demand and the economy."
"To stimulate aggregate
spending when short-term interest rates have reached
zero, the Fed must expand the scale of its asset purchases or,
possibly, expand the menu of assets that it buys."
Now let us go to his conclusion:
"Sustained deflation can be highly destructive to a modern
economy and should be strongly resisted. Fortunately, for the
foreseeable future, the chances of a serious deflation in the
United States appear remote indeed, in large part because of
our economy's underlying strengths but also because of the determination
of the Federal Reserve and other U.S. policymakers to act preemptively
against deflationary pressures. Moreover, as I have discussed
today, a variety of policy responses are available should deflation
appear to be taking hold. Because some of these alternative policy
tools are relatively less familiar, they may raise practical
problems of implementation and of calibration of their likely
economic effects. For this reason, as I have emphasized, prevention
of deflation is preferable to cure. Nevertheless, I hope to have
persuaded you that the Federal Reserve and other economic policymakers
would be far from helpless in the face of deflation, even should
the federal funds rate hit its zero bound."
Stimulating Aggregate Demand
Let's forget for the moment
the debate about whether Fed policy can actually stimulate demand
at all times and places. The quotes above demonstrate that Bernanke
and the Fed board believes that is does. Beliefs will translate
themselves into action. The Fed, when faced with slowing demand
and deflation, will act in very predictable ways based upon their
beliefs. They will work to stimulate demand.
Bernanke viscerally believes
in the ability of the Fed to stimulate demand and prevent deflation.
That is the lesson you need to take away from the Bernanke speech.
In a typical business cycle,
if the economy gets "overheated" and inflation starts
to rise, a central bank can raise interest rates and tighten
the money supply, thus slowing business growth and profits and
lowering demand and therefore price inflation. If the economy
gets into recession, a dose of low rates and easy money is the
prescription. "Don't fight the Fed" is a rule we have
been taught. It was a good rule to follow, until 2001, when there
was a disconnect between the markets and fed policy.
My concern is that we are not
in a typical business cycle. Just as a number of different economic
factors all came together to cause the boom and then bubble of
the 80's and 90's (disinflation, lower interest rates, lower
taxes, lower international tariffs, the demographics of the Boomer
Generation, stability, etc.), I think there are now forces at
work which may not respond to the Federal Reserves levers (such
as inflated housing prices, a monster trade imbalance, large
government deficits, huge personal debt burdens and a boomer
generation which will need to save more to retire, among many
issues). But that does not mean the Fed will not pull them.
For Bernanke, "Deflation
is in almost all cases a side effect of a collapse of aggregate
demand--a drop in spending so severe that producers must cut
prices on an ongoing basis in order to find buyers."
The deflation that will be
coming to us in our future will not come as a result of a drop
in aggregate demand, but as a result of excess production capacity
and the rising influence of China and other markets where cheap
labor accompanied by the build-up of too much production capacity
is driving down production costs. It is acerbated by the continued
competitive currency devaluation upon the part of many of the
trade partners of the US. This is a tide of deflation that is
sweeping the world. It is a global phenomenon, and not isolated
to just one economy.
My concern is that the United
States, in isolation, cannot prevent global deflation from coming
to our shores without help from the rest of the world. And to
date, we are not getting any help at all.
Bernanke is going to have a
difficult task as he faces a slowing US economy. When does he
shift policy? I doubt he knows today. But if he raises rates
too high or keeps them there too long, he risks more than a mere
slowing economy. Let's hope he has the touch. Stay tuned.
Detroit, New York and Dallas
I will be in Detroit next week,
New York two weeks after that and then plan to be home for the
next two months. I am looking forward to it. I apparently need
the rest. I have been tired the last few days, but remarked this
morning how I feel better today. My son, just turned 17 this
week, turned and looked at me while I was driving him to school
and said, "Dad, are you sure? You look pretty bad."
Ouch. Turns out, he decides I am having a bad hair day. But I
think I will sleep in tomorrow morning before I go to the gym,
just in case.
I will be making what is for
me an exciting announcement next week. Look for a special email
from me. Until then, have a great week and spend some time with
your family and friends and an adult beverage of choice.
Your 'deciding to relax more'
analyst,
John Mauldin
email: John@frontlinethoughts.com
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