Thursday, February 25, 2010

Telling the future by reading Ben Bernanke's mind.



Ben Bernanke is the Chairman of the Federal Reserve Board and so is the first among equals in setting the monetary policy of the United States. He is also the Shadow Governor of the Peoples Bank of China, the Saudi Arabian Monetary Authority, The Emirati Central Bank, The Hong Kong Monetary Authority, and the Banque du Liban. That is because any country with currency pegged to the US dollar imports US monetary policy. The purists among you will point out that the Renminbi is actually a managed float but if you punch up a graph of it vs. the dollar you will not that it is very managed and not very floating.

So if you live in the United States or any of these other countries or have a relationship with the dollar, (and if you consume petroleum, wear gold, or eat an internationally traded grain, you do) then you have to care about what Ben Bernanke is thinking. He controls the supply of dollars in the world and has a strong influence over the rates at which they are borrowed and lent. So what is he thinking? To answer that we have to take into consideration: first, what is his mandate; second, what kind of guy is he; and third, what makes him get out of bed every day.

Ben Bernanke’s Mandate is to maintain price stability while promoting the maximum sustainable employment in the US.

Bernanke is required to keep inflation low while at the same time promoting substantial economic growth in the US. Note that I say the US. The Chairman has no responsibility to the economies of the nations which peg their currencies to the dollar. This has caused some issues for the Gulf states in the past and is currently exacerbating the concerns of the Chinese government about their economy potentially overheating. Bernanke does not care. He cares about the US and only the US.

Ben Bernanke is a very smart economist, a very creative central banker and has a generally Monetarist outlook.

Ben Bernanke is a Harvard and MIT trained economist who had a successful academic career ultimately chairing the Princeton Economics Department before joining the Federal Reserve. His tenure at the Federal Reserve has been marked by furious activity. The Fed used all of its usual powers such as the discount rate to their maximum extent, then used some that people never thought it would use like quantitative easing and finally Chairman Bernanke invented others like the alphabet soup of liquidity facilities when he felt the need arose. I consider him, and I think he would consider himself, a Monetarist. By a monetarist I mean that he believes that the money supply is one of the most important factors in determining macro-economic performance both in terms of growth rates and inflation. This view has informed his reactions to the crisis thus far.

Ben Bernanke makes more money from royalties on textbooks than he does for being Chairman of the Fed. He gets out of bed every day because he has a real chance of becoming the greatest Central Banker in the history of the world.

This may sound odd because Bernanke has been at the center of the storm over the financial crisis and its aftermath. He is a target for blame because he does bear some responsibility for the origin of the crisis and many of his decisions in its resolution have been controversial. His actions to preserve the financial system have distributed aid unevenly and enriched some who the public believes should be punished. He has been attacked from every point of the political compass indeed the high priestess of Monetarism has practically excommunicated him in an editorial in, of all places, the New York Times.

But to focus on the current press is to miss the larger picture. Bernanke was not the only guy responsible for the financial crisis but he is one of the few who does not have to run for election so a lot of people have sought to shift blame to him. The crisis has had a thousand authors but its resolution was written with a single hand: Bernanke’s. The world financial system was on the edge of collapse and Ben Bernanke brought it back by releasing as much liquidity into the world financial system as if he had broken open a Hoover Dam holding back an ocean of money. When that liquidity hit the markets maybe the wrong people got soaked with cash but the drought was over. This is why he is half way home to being the most successful central banker in the history of the world: people won't remember how he saved the financial system, they'll remember that he saved it.

The other half of it has to with how he soaks up that liquidity. The current holder of the title for best Central Banker in US history now that the Greenspan legacy seems to be as a bubble blower is Paul Volcker. Volcker is famous for killing the great inflation that plagued the US for most of the 1970s by jacking interest rates to the moon in 1980-81. This caused what at the time was the deepest recession since the Depression and put Volcker under massive political pressure but he stood tall, the country took the pain, the inflation subsided and set the stage for a high growth low inflation regime that has lasted almost to this very day. Given the amount of liquidity that Bernanke has poured into the system it is likely he will get the chance to pull a Volcker in addition to is rescue of the financial system.

What does this all mean for what’s ahead?

There has been a ton of speculation in the press and the markets about when the Fed is going to start tightening. There is a lot of concern that Fed tightening is imminent and that if the Fed jumps in too early it will kill the recovery in the crib. If it jumps in too late there will be inflation which, once it gets started is really hard to kill off without a massive recession. Personally I think you can take the three points above to predict what the future holds. Here’s what we know:

1.) Ben Bernanke can go down in history as the greatest central banker ever if and only if he can prevent his massive injection of liquidity from generating significant inflation. To do that he has to begin tightening before the CPI is actually registering inflation. Also as a monetarist, if forced to choose between price stability and employment Bernanke will choose price stability meaning he will risk a deeper recession if necessary to forestall inflation.

2.) Thankfully there is no sign that inflation is even on the horizon so Bernanke is likely to stand pat for a while and let the economy recover. As a monetarist Ben Bernanke believes that inflation is fundamentally a monetary phenomenon. Therefore his signal that inflation is on the horizon is going to be the monetary aggregates, such as M2, which have been stagnant or declining despite the massive amount of liquidity with which he has flooded the system.

3.) So now you know the future because you know what Bernanke is going to do. He is going to sit on his hands and let the loose monetary policy inflate asset prices, repair bank balance sheets, and hopefully stimulate the economy back to recovery before the monetary aggregates turn up. Once M2 starts creeping up, look out because Bernanke will act aggressively to head inflation before it gets going. Once there is more clarity on the Greek situation asset prices in the US dollar bloc have nowhere to go but up until the monetary aggregates turn upwards and Ben Bernanke responds to the bat signal. You heard it here first.

1 comment:

Anonymous said...

Bernanke gave a speech on using monetary policy to avoid Japan-like lost decades in 2002, speaking specifically about using the Fed balance sheet to target long-term rates: http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021121/default.htm
Towards the middle and end of last year, we heard constant drum banging by Wall St. analysts that it wasn't a question of if but when on inflation, despite clearly slack labor markets. This has obviously proven hasty. Macroeconomics is a slow process. Zero % overnight interest rates doesn't mean that no one will do anything to reverse course before they become a problem. We have roughly 5% of our work force to work through; we'll get plenty of time and plenty of notice to put the brakes on before it becomes a problem. We can even probably blow a red light or two and still be ok.
I still don't know where this leaves the dollar, though.