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The Ben Bernanke Grand Experiment

(October 27, 2005)

Dear Subscribers and Readers,

I believe one of the best business publications out there is Business 2.0.  Sure, the reporting isn't as comprehensive as say, Fortune, but the lead time is dramatically quicker.  One can find stories in Business 2.0 that won't be reported for months in the major business publications, such as Fortune, Forbes, and Business Week.  In terms of looking for and capitalizing on new trends and ideas (and which old ones to potentially throw out), this is one publication to read.  As for the style of reporting - well, I am sure that the optimists in all of us will like it.  This month's lead article is entitled: "The Next Real Estate Boom."  Sounds repetitious?  Well, the authors caveat that with "Short-Term Bubble?  Maybe.  Long-Term Opportunity?  Definitely."  Instead of studying at the upcoming real estate "boom" in this country from purely a financial standpoint, the authors of this article compiled statistics on urban planning, as well as shifts in demographics and upcoming industries.  The conclusion: "Ten megapolitans are poised for a development boom that, by 2030, will dwarf America's post-WWII buildout."

Now Henry, aren't you relatively bearish on homebuilding stocks and on residential real estate right now?  Do you believe there is a possibility of the above scenario emerging?  Answer to first question: Yes, I still am.  I am bearish because of the immense amount of speculative activity in various areas of the United States.  I am bearish because of the record high amount of real estate assets held by households as a percentage of their total assets.  I am also bearish because the rise in real estate prices in selected areas in the United States have been very much out-of-line relative to historical trends.  However, it is important to keep in mind that even if the scenario as envisioned by Business 2.0 emerges, it does not necessarily mean higher housing prices in general for these ten geographical areas.  In fact, if the urban planners are anywhere near as successful as they plan to be, housing prices in many of these areas should be affordable to the median population.  This is currently not happening in parts of California, Nevada, Arizona, Florida, etc.  In other words, today's speculators can still be ruined even if the above scenario pans out - and rightly so.

Okay Henry, how about your answer to the second question?  In the long-run, I remain optimistic on the U.S. real estate market, the U.S. economy, and cautiously optimistic on the world economy in general.  It is very important to keep in mind that for the first time in world history, we have not witnessed any systematic damage to the infrastructure of the world's major developed countries for the last 50 years.  The last major war was World War II.  Today's boomers are actually starting to inherent substantial amounts of assets from their parents, and the children of the boomers will inherit even more going forward.  This also holds true in other developed countries such as countries in Western Europe, Japan, Australia, New Zealand, and South Korea.  In addition, the fact that the countries of China and India are becoming more economically open and capitalistic should mean an age of prosperity that have never been witnessed before in world's history.  From the investor's standpoint, there will be many, many opportunities to accumulate wealth going forward.  This may sound like a cliché - but it is important to not have an "us vs. them" mentality if one is to thrive in this globalized world of ours going forward.  All right, I guess it is okay if we are rooting for opposing sports teams, but the analogy ends here.

Since this is supposed to be a commentary on the newly-appointed Fed Chairman, let's end the discussion of Business 2.0 and real estate right here.  But I urge our subscribers to check out the publication - especially investors who are keen to invest in growth stocks.  Sure, some of you may not like the writing style - but the lead time that one obtains in terms of upcoming technologies and trends is invaluable.  One thing that I have learned over the years (and reminded every now and then) is that the market is not efficient all the time - even with the proliferation of the internet and the continuing globalization of the world.  This is especially true with new technologies, and of course, with new and emerging markets (whether they are products or countries).  And don't forget: Sometimes all you need to be successful is one major idea or one major theme.

Let's now discuss Dr. Ben Bernanke and the implications of his appointment for Fed Chairman.  I had previously intended to title this commentary "Ben Bernanke: Great Inflationist or Inflation Fighter?" but I did not think that the title would do him justice.  Through his long career as an academic in both MIT and Princeton and his stint as a member of the Board of Governors at the Federal Reserve, Bernanke has written extensively and has made many speeches outlining his views on the Federal Reserve and the U.S. economy, and the many ways that both of these can be "managed," so to speak.  By far, the most notable speech that he made - and the most widely publicized - was the speech that propelled him to the spotlight in the investment community and which subsequently had many in the community naming him "Helicopter Ben."  The speech was made on November 21, 2002, and mainly focused on the possibility of deflation and what the Federal Reserve can do to make sure that a deflationary recession does not occur here in the United States.  Bernanke then goes on to discuss why the Federal Reserve will not "run out of ammo" even after they have cut the Fed Funds rate all the way to zero.  Following are some notable quotes from that speech:

So, is deflation a threat to the economic health of the United States? Not to leave you in suspense, I believe that the chance of significant deflation in the United States in the foreseeable future is extremely small, for two principal reasons. The first is the resilience and structural stability of the U.S. economy itself .

The second bulwark against deflation in the United States, and the one that will be the focus of my remarks today, is the Federal Reserve System itself. The Congress has given the Fed the responsibility of preserving price stability (among other objectives), which most definitely implies avoiding deflation as well as inflation. I am confident that the Fed would take whatever means necessary to prevent significant deflation in the United States and, moreover, that the U.S. central bank, in cooperation with other parts of the government as needed, has sufficient policy instruments to ensure that any deflation that might occur would be both mild and brief .

Although deflation and the zero bound on nominal interest rates create a significant problem for those seeking to borrow, they impose an even greater burden on households and firms that had accumulated substantial debt before the onset of the deflation. This burden arises because, even if debtors are able to refinance their existing obligations at low nominal interest rates, with prices falling they must still repay the principal in dollars of increasing (perhaps rapidly increasing) real value. When William Jennings Bryan made his famous "cross of gold" speech in his 1896 presidential campaign, he was speaking on behalf of heavily mortgaged farmers whose debt burdens were growing ever larger in real terms, the result of a sustained deflation that followed America's post-Civil-War return to the gold standard .

Beyond its adverse effects in financial markets and on borrowers, the zero bound on the nominal interest rate raises another concern--the limitation that it places on conventional monetary policy. Under normal conditions, the Fed and most other central banks implement policy by setting a target for a short-term interest rate--the overnight federal funds rate in the United States--and enforcing that target by buying and selling securities in open capital markets. When the short-term interest rate hits zero, the central bank can no longer ease policy by lowering its usual interest-rate target.

Bernanke then discusses the role of the Fed to act more preemptively and to be more of an activist Fed - by making sure that the U.S. economy does not fall into deflation.  Bernanke claims the Fed can do so via the following three traditional measures:

  1. Creating a buffer zone for the inflation rate.  That is, the Fed should not try to push the inflation rate all the way down to zero even when the economy is healthy.

  2. Seek to ensure financial stability in both the U.S. and the world economic system.  The banking system needs to stay well-capitalized in order to defend against adverse shocks to the system, such as during the October 1987 crash and the September 11, 2001 terrorist attacks.

  3. And "third, as suggested by a number of studies, when inflation is already low and the fundamentals of the economy suddenly deteriorate, the central bank should act more preemptively and more aggressively than usual in cutting rates"

But should the U.S. economy ever slip into deflation despite all these measures, Bernanke claims there are other measures available to the Fed and to the President to stimulate the economy and induce inflation, such as bringing down interest rates in maturities further up the yield curve - up to two years or even three to six years, as well as buying debt in the agency markets.  This is not an unprecedented move by the Fed, as "Historical experience tends to support the proposition that a sufficiently determined Fed can peg or cap Treasury bond prices and yields at other than the shortest maturities. The most striking episode of bond-price pegging occurred during the years before the Federal Reserve-Treasury Accord of 1951."

In the very unlikely chance that the above measures are not sufficient to stimulate the economy, Bernanke claims that there are still further options available to the Fed - including an attempt to influence yields on private securities, or to lend money at a zero interest rate to the private sector - indirectly via banks through the discount window.  Finally, the Fed, acting on its own, can also purchase foreign debt, as well as domestic government debt.

Interestingly, the helicopter reference does not come up until towards the end of his speech - when he discusses the final "trump card" that can be played - should the Federal Reserve ever fail to successfully fight deflation on its own:

Each of the policy options I have discussed so far involves the Fed's acting on its own. In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices. Even if households decided not to increase consumption but instead re-balanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers. A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money.

It is unfortunate that the last sentence of the above paragraph was completely taken out of context and blown very much out of proportion.  It is also unfortunate that most members of the investment community and also the media has also focused on his deflation speech, as opposed to many of his other writings and speeches since that date. 

One of his most notable "anti-dove" speeches came on October 17, 2003, when he discussed whether the Federal Reserve should adopt a "quantitative inflation objective - and whether this will improve the efficiency of U.S. monetary policy going forward.  First of all, Bernanke claims that in today's environment of "near price stability" (note: this speech was made when oil was still lower than $40 a barrel), an effective communication policy from the Federal Reserve is very important, as the "public can no longer safely assume that the central bank prefers lower to higher inflation, expectations about future policy actions and future inflation may become highly sensitive to what the public perceives to be the Fed's "just right" level of inflation. Uncertainty about this "just right" level of inflation thus may translate, in turn, into broader economic and financial uncertainty. Second, at very low inflation rates, the zero lower bound on the policy interest rate is more likely to become relevant, which increases the potential importance of effective expectations management by monetary policymakers."

Bernanke then proposes on the possibility of explicit inflation targeting by the Fed - in the form of an announcement of a preferred long-run inflation rate - which he terms the "optimal long-run inflation rate," or OLIR for short.  I highly recommend our readers to read the full text of his speech.  In a nutshell, Bernanke proposes a policy of direct, effective communication with the private sector on an optimal long-run inflation rate.  Quoting from his speech:

If announcing the OLIR does not constrain short-run policy unduly, I really cannot see any argument against it. To reassure those worried about possible loss of short-run flexibility, my proposal is that the FOMC announce its value for the OLIR to the public with the following provisos (not necessarily in these exact words):

(i) The FOMC believes that the stated inflation rate is the one that best promotes its output, employment, and price stability goals in the long run. Hence, in the long run, the FOMC will try to guide the inflation rate toward the stated value and maintain it near that value on average over the business cycle.

(ii) However, the FOMC regards this inflation rate as a long-run objective only and sets no fixed time frame for reaching it. In particular, in deciding how quickly to move toward the long-run inflation objective, the FOMC will always take into account the implications for near-term economic and financial stability.

As you can see, stating the OLIR with these provisos places no unwanted constraints on short-run monetary policy, leaving the Committee free to deal with current financial and cyclical conditions as the Committee sees fit. In this respect, the proposal is very similar to one recently advanced by Governor Gramlich (2003) .

Without any fixed time frames for reaching the optimal long-run inflation rate, would an announced value for the OLIR carry any credibility? I think it would, for the important reason that the OLIR is not an arbitrarily selected value .

And the following quote is perhaps one of the most important paragraphs in his speech, even though it may have been overlooked by most of the media:

Additional reasons that the announcement would carry weight are the accumulated credibility of the Fed and the fact that we are presumably starting from a point near the optimal inflation rate, so that a period of costly disinflation will not be needed to reach the OLIR. In other words, this relatively unconstrained approach might not work for other central banks, and it might not have worked for the Fed at other times (e.g., when we were at early stages of the disinflation process); but given the current configuration of circumstances, it should work now.

The above paragraph is very significant.  Bernanke claims that this optimal long-term inflation target policy would only work and be credible if we are at "a point of near optimal inflation."  Well, folks, we are now in the "sweet spot" in terms of price stability, as Bernanke puts it, and from the speeches that he has made and written about inflation in the past, it looks like Bernanke will be very active in trying to maintain the U.S. economy at that "sweet spot."  With some leading inflation indicators making new highs, I would not be surprised if Bernanke ultimately becomes more "hawkish" or preemptive than Greenspan in raising the Fed Funds rate.  That is, the market (in pushing the yield of the long bond and stock prices higher) may very well have misinterpreted his intended policy for the Federal Reserve both in the short-run and in the long-run.  It also notable that Bernanke has communicated that he does not feel the Fed Funds rate has much of an effect on stock prices (and that monetary policy should also generally not take asset prices into account).  This is further evidence that Bernanke will not be hesitant about raising the Fed Funds rate to a level that is higher than is currently implied by the Fed Fund futures should he believes that inflation is still not well-contained come early next year.

Therefore, it is not fair to label Dr. Bernanke as a "dove" or even a "hawk."  What should be clear to us, however, is that Dr. Bernanke believes that the Federal Reserve should play a hugely active role in regulating the economy (okay, I bet some of you does not like that word) - whether it is in curbing deflation or inflation.  Finally, let's keep in mind that Dr. Bernanke is a scholar and an academic at heart - that is, unlike bankers and civil servants who have become rigid in their ways (similar to what the European Central Bank and Bank of Japan have been experiencing more often than not), Bernanke will not be afraid to change the policies of the Federal Reserve or to actively implement his academic ideas - some of them which have only previously been written on paper.  More significant than the role of an activist Fed, this author believes that Dr. Bernanke, in the role as Federal Reserve Chairman, will push the Federal Reserve into policies that have never been implemented, such as the targeting of an explicit inflation rate or implementing "unconventional policies" should the U.S. economy ever threaten to slip into deflation.  The era of the "Ben Bernanke Grand Experiment" is now upon us.

Signing off,

Henry K. To, CFA

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