The Fed Show. Bernanke Speaks

Fed Chairman Ben Bernanke held the first-ever press conference. By most accounts, the event was anticlimactic. However, I was able to reaffirm what I had already believed about his mindset. In a nutshell, Bernanke still believes that it is too risky at this point to change the Fed’s monetary policy or statement. He says that the economic recovery is progressing, but at a sub-par pace. Therefore, we can expect exceptionally low levels of interest rates for an extended period (which he defined as at least a couple of Fed meetings). Seventy-five percent of economists in a recent survey believe that the Fed will raise rates prior to year-end. Count us among the dissenters. We expect the Fed to stop reinvesting principal payments in its $2.8 trillion portfolio long before we hear any talk of increasing the discount rate. We believe weakness in housing will be the primary constraint in monetary policy decisions.

With regard to inflation, and specifically the impact of a weakening dollar on commodity inflation, Bernanke continues to say that there are more important factors driving the price increases. He says demand for commodities is very high due to rapid growth in emerging economies. At the same time, we have experienced supply disruptions due to geopolitical shocks. He believes the increase in oil and other commodities will be transitory, and that there is not much the Fed can do about higher gas prices in the near term. With regard to the sinking dollar, he says the best things the Fed can do to support a strong dollar are to implement policies that stimulate growth and contain inflation. He also side-stepped and said that the dollar was really in the domain of Treasury Secretary Geithner. While he may be correct in his assessments about oil, it is hard to reconcile the sharp spike in the price of precious metals like gold and silver.

Bernanke is obviously most concerned about the weak pace of employment growth. The Fed’s dual mandate requires him to focus on employment as well as price stability. However, it appears as though Bernanke’s strategy with regard to employment is to increase stock prices. He believes that if stocks go up, consumers will start spending again and this will lead to higher corporate profits and more investment in new employees. So far, we have seen a massive increase in stock prices, an increase in consumer spending, but not a robust increase in job creation. Moreover, consumers are feeling the effects of higher food & energy costs, which decrease the amount of money they have to spend on other discretionary purchases. Therefore, it seems to me that Bernanke’s monetary policy may be counterproductive at this point. Does he believe that higher stock prices alone will recover the 8 million lost jobs? If not, what will?

The Fed’s push for higher share prices is classic Reagan “trickle-down” policy. Reliance on confidence built on higher share prices creating the confidence to hire and spend has sort of worked. High end consumers have been consuming while the Walmart shopper has been left behind. We have written a good deal about our concerns about the increasing concentration of wealth and the bifurcated consumer. It is unclear if this policy will be effective, but we see very few other options.

Bernanke did in fact address the question as to why the Fed is not doing more to stimulate job growth. His answer was perhaps the best nugget of information we got today. He said that the tradeoffs have now become more negative because inflation and inflation expectations have crept higher. This is very important because it means that the Fed may be highly reluctant to implement a QE3 once QE2 has expired. The markets didn’t seem to mind this answer.

In my opinion, the elephant in the room is housing. Bernanke knows that the Federal government is the only game in town for housing finance, and he also knows that the government must extricate itself from this position at some point. He also knows that housing prices are falling again as foreclosures and distressed sales increase after a short moratorium. Bernanke cannot risk a rise in interest rates right now as it would only make the housing situation much worse. Banks are already unwilling to make mortgage loans because they fear further home price declines and are uncertain about future regulatory issues and capital requirements. The housing market is just beginning to clear, and we expect it will clear at much lower levels. Recent data support this as housing sales are showing slight increases but at lower prices. Bernanke knows this as well, and his monetary policy is in no small part determined by this reality.

As expected, Bernanke also strongly encouraged Congress to get deficits under control, with particular emphasis on bringing down the long-term structural deficits through a restructuring of entitlements (SS, Medicare). A massive selling of longer-term Treasury bonds, triggered by fears of endless budget deficits, is obviously the biggest risk to our economy at this point. Rising long-term interest rates would crush housing and stop the recovery in its tracks. Therefore, it is not surprising that Bernanke took Congress to task once again. In fact, he went so far as to say the move by S&P to put the US on credit watch could be helpful as it may force Congress to act.

It appears that “The Fed Show” events have encouraged investors. Bonds yields remain low (supported by the commitment to complete QE2), and stock prices are higher. However, the dollar continues to fall, causing further increases in commodity prices. Gold and silver are soaring as well. Bernanke continues to hang his hat on the fact that intermediate-term inflation expectations remain well contained. He believes this is so because investors trust the Fed to act when necessary to contain runaway inflation. Is he right? Only time will tell…

Peace,

Michael