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2 Playing 'chicken' with the
markets By Julian Delasantellis
Any parent knows that sometimes you have
to tell a child something more than once to get
your point across. If you’re dealing with a
teenager who has been allowed to have his or her
own way for too long, you may have to repeat the
message that things have changed, that there are
new expectations, a few times before it sinks in.
That’s what US Federal Reserve chairman
Ben Bernanke is doing with the markets these days
- trying to send the message that
he’s
instituting new rules of conduct, of proper
behavior, for both the Fed and the markets.
Will the markets get and accept the
message? We’ll know at the next Fed meeting, on
December 11.
In a speech delivered to the
Cato Institute in Washington on Wednesday,
Bernanke expounded his views on what should be the
proper inputs that influence the policy decisions
of America’s central bank. Taken together they
indicate that, now 21 months into his 7 year term
as chairman, he has finally found footing and
confidence sufficient to make a fairly significant
policy change from his predecessor, the
illustrious Alan Greenspan.
The first
major change elucidated by Bernanke refers to a
new emphasis on what is called “overall”
inflation, in the place of a previously greater
focus on what is called “ core” inflation.
The distinction between core and overall
inflation is simple to understand. Overall
inflation is a measure of price increases in that
place economists are rarely concerned about, the
real world. It’s what you feel when you get a
haircut, go out to dinner, and especially these
days, fill your car with gas.
But,
traditionally, overall inflation has not been the
preferred inflation gauge for economists. In its
stead, they have favored looking at something
called “core” inflation, defined as price changes
for retail goods excluding food and energy.
There are some good reasons, other than
economists’ traditional desire to live in a
fantasy world, to look at core inflation. Energy
and food prices are much more volatile than prices
of other consumer goods, they frequently are
affected by many factors unrelated to the basic
health or weakness of the underlying economy.
Killing freezes in Florida (which, most likely due
to global warming, are now much less frequent than
they used to be) can cause price spikes in winter
citrus, and geopolitical tension in the oil
producing regions regularly produces what is
called a “fear premium” in oil and oil products
prices.
By removing these volatile
factors, the argument goes, you get a better look
at whether economic growth or weakness, which, in
contrast to the weather or OPEC, the Fed can
control, is causing the general level of prices in
the economy to rise or fall.
But the
drawback of core inflation is that, in times such
as these, with food and energy prices rising
rapidly, the Fed loses credibility when it says
that core inflation only rose 0.2% in October, and
consumers then compare what they hear from their
leaders with what they see on their supermarket
check out tape and on the price signboards of
gasoline stations, which are currently now
America’s real inflation index.
Therefore,
Bernanke is now saying that the Fed is going to
tip the scales a bit back towards reality.
"Ultimately, households and businesses
care about the overall, or 'headline' rate of
inflation; therefore, the FOMC [Federal Open
Market Committee] should refer to an overall
inflation rate when evaluating whether the
committee has met its mandated objectives over the
long run. For that reason, the committee has
decided to publish projections for overall
inflation as well as core inflation. In its policy
statements and elsewhere, the committee makes
frequent reference to core inflation because, in
light of the volatility of food and energy prices,
core inflation can be a useful short-run indicator
of the underlying trend in inflation. However, at
longer horizons, where monetary policy has the
greatest control over inflation, the overall
inflation rate is the appropriate gauge of whether
inflation is at a rate consistent with the dual
mandate.”
But the real impact of this
policy change is to make future Federal Reserve
interest rate cuts less likely, and probably less
frequent. The tremendous economic growth of the
petroleum-poor economies of China and India has
been spurring oil demand for much of this decade.
As for food demand, that is also being driven by
these countries' newly elevated living standards,
as well as the not insignificant factor of
agricultural production once dedicated to
foodstuffs now being diverted to the production of
ethanol. If you are going to re-focus your
monetary policy on inflation, and if you are going
to measure inflation in such a way that it makes
inflation look worse than previously, then, in
effect, the Fed is tying itself up in a
straitjacket of its own knitting in regard to
future rate cuts.
But the real change in
Bernanke’s speech was related to what is called
"inflation targeting". In my September 18 ATol
article, A rate cut with a shoeshine and a
smile, and in my October 6 review of
Alan Greenspan’s autobiography, The Age of
Turbulence, (Reaping what is sown) I
noted how, throughout Greenspan’s 18-year tenure
as Fed chief, and continuing into the early months
of Bernanke’s, it frequently seemed that pure
economic fundamentals were of secondary importance
in deciding whether or when to change short-term
interest rates, especially if that change was a
rate cut.
After taking office as Fed chief
in August 1987, Greenspan’s first move was to show
off his monetary masculinity with half point hikes
in the Federal Funds target and discount rates on
September 4; six weeks later came the crash of
'87. Greenspan was stung by charges that his first
rate move caused the debacle, notwithstanding the
fact that these charges arose from Wall Street
types who wouldn’t have known the difference
between selling stocks and selling shoes.
Greenspan cut rates repeatedly in the three months
after the October 1987 crash, and the economy
recovered rapidly; the fears that the market
calamity might act similarly to the Crash of 1929
and produce another Great Depression proved
unfounded. The pattern was set, the stock markets
came to realize that they could always rely on
chairman Greenspan.
From July to December
of 1990 the markets sold off nervously in response
to Iraq’s invasion of Kuwait, and the Dow Jones
Industrial Average lost over 16% of its value. In
response, the Greenspan Fed cut the Federal Funds
target rate five times. In mid 1998, as the Dow
sold off 11%, over 1,000 points, and as the East
Asian financial crisis concluded with the
bankruptcy of the Long Term Credit Management
(LTCM) hedge fund, the Fed cut again, trimming 75
basis points off the Federal Funds target rate.
At the opening of trading on September 17,
2001, the first day of trading after the four-day
shutdown caused by 9/11, Greenspan welcomed the
markets back with a 50 basis point cut. After a
brief recovery rally in the autumn of 2001 the
markets continued to fall, spooked by both the
gathering evidence of a US economic slowdown and
the Iraq war talk coming from Washington. The Dow
Jones bottomed out under 7,200 in early October
2002, down almost 40% from its highs in early
2000. Over that period, the Greenspan Fed cut
rates 12 times; lowering the Federal Funds target
rate to 1.25% as the rate cutting cycle concluded.
Of course most of these rate cuts did
occur in times of great economic stress, but,
after a while, it began to seem as if Greenspan
was using the level of the stock market not as a
predictor of future economic disruption, but
almost as a proxy for it. After that, it was a
just a natural extension of the implied logic to
assume that the stock market declines were not
just a
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