The good news about the nomination of Ben Bernanke for a second term as head of
the United States Federal Reserve is that 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.
Until recently, banking was 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 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.
In all seriousness though, we believe central banking is more predictable than
it may seem, and 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 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.
This is a fairy tale promoted by Bernanke, amongst others. In our humble
opinion, and our understanding of the facts, inflationary expectations, not the
output gap, are 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.
Expectations management is 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 3.5% at the time: talk was not good enough anymore, the Fed needed to
act. Since then, the Fed has printed well over US$1 trillion 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 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 engaged in by Bernanke have veered off the
path of what central banking is all about: rather than supplying the asphalt,
he is patching up the roads.
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. 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 the activities the
Fed has been engaged in may be far more difficult to unwind (or "neutralize")
than it 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% 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, that is, 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 US 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, US institutions are increasingly
hedging their US dollar risk, something unheard of in a developed country in
years past.
Axel Merk is manager of the Merk Hard and Asian Currency Funds. Merk
Insights provide the Merk perspective on currencies, global imbalances, the
trade deficit, the socio-economic impact of the US administration's policies
and more. To learn more about the Funds, or to subscribe to our free
newsletter, please visit www.merkfund.com.
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