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US Markets May Be Heading For a Bernanke 'Trap'

 
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PostPosted: Wed Feb 15, 2006 11:02 pm    Post subject: US Markets May Be Heading For a Bernanke 'Trap' Reply with quote

International Perspective, by Rob Lee

The US Economy and Markets may be heading for a Bernanke 'Trap'
February 8, 2006

Rob Lee is an economist who has been involved in investment markets for 30 years, the last few in nominal retirement in the U.K..

Much has been written recently about Alan Greenspan’s tenure as Fed Chairman, most of it very positive. I recall the (apocryphal?) story of the Chinese history professor who was asked to sum up the impact on Europe of the French revolution. After some thought he replied “ It is too early to tell”. My feeling is that reviews of Mr Greenspan’s record written in five to ten years time will be much more critical than those written now.

Nevertheless, it is a remarkable fact the US economy suffered only two recessions during his 18 years at the Fed, both of which were relatively short and mild. Furthermore, Mr Greenspan dealt successfully (apparently) with a series of financial crises. These include the 1987* stock market crash, the savings and loans debacle of the early 90‘s, the Asian crisis, the LTCM rescue, the Millenium bug scare, and the Nasdaq crash of 2001/2. The “cure” for these ills was always the same - massive infusions of liquidity and aggressive cuts in short term interest rates. (Few seem to question whether the cure may itself be responsible for the unnerving recurrence of such crises, but that is a topic all of its own.)

In Mr Greenspan’s skilful hands monetary policy has apparently demonstrated itself to be virtually all powerful. This in turn has produced an extraordinary degree of confidence and complacency among US investors, businessmen, and consumers. In this state of mind truly staggering imbalances - most notably the huge current account deficit, the collapse in the savings rate, and an obvious housing bubble - are regarded with insouciance.

Enter stage left Ben Bernanke, former Fed Governor and incoming Fed chairman. Here is a successor who has promised to follow in Mr Greenspan’s footsteps. Indeed he is on record as supporting or contemplating an even more aggressive use of monetary policy in circumstances of crisis. So no problem then. If the economy or markets show signs of turning down, Mr Bernanke can be relied upon to work the same magic, and then some. This seems to be the consensus view, but I think it is wrong. I think that the US economy and markets are heading for a trap.

In my view US monetary policy already is tighter than intended or perceived, and is likely to become more so in the early part of Mr Bernanke’s term in office. Thus the US economy is heading for recession and the stock market for a major downturn. I expect this for the following reasons:

1. Monetary policy operates with long lags, in the US as much as 12-18 months. Therefore even if rates are not raised any further there is still a considerable degree of tightening to come. The remarkable growth in the use of adjustable rate mortgages in recent years may accentuate this factor, as very large numbers of mortgages revert to market rates over the next two years.

2. Although interest rates are relatively low in historical terms, whether real or nominal, they may still prove uncomfortably high in the context of unprecedented debt levels. Furthermore, the degree of tightening that has taken place - a cumulative 350 basis points in the Fed Funds rate - is already more than that which has led to recessions in the past.

3. The underlying economy is probably already weakening significantly. The very low level of growth recorded in 4Q 2005 has been dismissed as an aberration but I am not so sure. The housing market has been a key driver of growth in recent quarters. My impression from the data, and from various (admittedly) anecdotal sources, is that the boom is over. Bust is not yet here but history surely suggests it is coming.

4. The single most reliable leading indicator of future economic slowdowns/recessions is an inverting/inverted yield curve (that is short term rates higher than long term). The yield curve has been inverting sharply for some months and recently became (narrowly) inverted across most maturities. Many have dismissed the yield curve indicator, arguing that this time is different. Now where did I hear that one before…? Narrow measures of money supply growth also have a respectable record in predicting economic weakness. Although broad M3 money growth has risen sharply in recent months, M1 and M2 growth remains at levels more consistent with slowdown/recession.

5. The fiscal policy bullet was well and truly shot in reaction to the 2001/2 downturn. The Bush administration is now busy trying to control the federal deficit. These efforts may well prove ineffectual, but it seems very unlikely that the economy will be rescued by another fiscal boost. Naturally the fiscal deficit will increase in the event of a recession but by definition this will not have prevented one occurring.

6. The Fed statement after its last meeting indicated at least one more rate hike is likely, with more possible. Such expectations are now embedded in the Fed Funds futures markets. Clearly the Fed is at liberty to change its mind, but this is not typical of how institutions operate. There is usually a period of indecision before a change of course is possible. It is conceivable that Mr Greenspan would have been able to engineer a quick turnaround, given his undoubted credibility and authority within the Fed and in the markets. It is very doubtful that a novice Chairman could operate in the same way. This is part of the Bernanke trap that I see approaching.

7. The next part of the trap may be Mr Bernanke’s advocacy of inflation targets. Mr Greenspan shied away from this approach in order to give himself and the Fed maximum flexibility. Clearly it would take Mr Bernanke some time to persuade his colleagues and Congress to formally adopt an inflation target. In the meantime though it would appear inconsistent to ease policy while inflation was pushing up to or through potential target ceilings. Unfortunately for Mr Bernanke that is exactly what inflation is doing at present. Admittedly inflation targets are typically set two years into the future, so he could argue that inflation is forecast to fall in the future if he wished to cut rates. However, the subtlety of this argument may not appreciated by bond and forex traders contemplating massive trade deficits.

8. The trap is further deepened by the unfortunate reputation that Mr Bernanke has generated for himself. The following is an well known extract from a speech Mr Bernanke gave in November 2002:

“ Like gold, U.S dollars have value only to the extent that they are strictly limited in supply. But the US government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S dollars at 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 …inflation.”

It should be emphasised that this was no off the cuff remark, but contained in a set speech while he was already a Fed governor. He has repeatedly expressed these and similar views since. Of course his analysis may very well be correct, but it was not wise of a potential future Fed Chairman to say so. Central bankers around the world were privately aghast. Let’s face it, the sobriquet “Helicopter Ben” is not helpful to the man now in charge of the world’s reserve currency. Mr Bernanke must be well aware that he has this reputation for being weak on inflation. Is it likely that his first move as Chairman will be to ease policy? No. Does he have less room for manoeuvre than Mr Greenspan, both within the Fed and with markets? Yes.

In summary, I think the US economy is already slowing significantly. Monetary policy is tighter than it appears. Mr Bernanke’s Fed will (partly inadvertently) tighten policy even further and initially be slow to react to the resulting downturn in the economy and markets. Later down the road Mr Bernanke may get to implement his wilder ideas on monetary policy. Interesting times lie ahead!

* On a personal note, in 1987 I was working as Chief Economist for a large life insurance company in South Africa. On Oct 1st I became portfolio manager in charge of the company’s main investment assets. I inherited portfolios that were stuffed to the gills with equities. Three weeks later the portfolios had lost more than 20% of their value in the “crash”. A bit of a baptism of fire!
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