By Julian Delasantellis
... 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".
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 arbinger of future economic distress; they were, in effect, the actual economic distress that had to be countered with rate cuts. It began to be said that one of the factors that was underpinning the strong rally in stock prices that began late in 2002 was the existence of what was called the “Greenspan put”, a put being a stock option instrument that an investor uses to put a floor under any potential losses in an equity he owns. In effect, by seeming to always come to the rescue of a stock market in trouble, the stock market acquired the impression that the US Federal Reserve would always be there to bail them out.
Bernanke, who appeared to be following this pattern with his rate cuts of August and September, now seems to want to disabuse the markets of this notion. In my November 2 ATol article, Bernanke: Don't take me for granted, boys <http://www.atimes.com/atimes/Global_Economy/IK02Dj01.html>, I noted that there were leaks emanating from the Federal Reserve regarding a desire to change the market’s expectation that stock selloffs would always be met with rate cuts. In his Cato speech, Bernanke further expanded on these ideas.
Bernanke seems to desire moving Fed policy away from Fed cuts to be expected upon market hiccups towards a policy called “inflation targeting”, common with other central banks such as the Bank of England.
Very much as the name implies, inflation targeting means setting a formal inflation goal, and altering policy in order to zero in on the desired goal, for instance, raising rates to tighten monetary policy should inflation be coming in above the target goal.
Bernanke informed Cato of his views on inflation targeting. “As you may know, I have been an advocate of the monetary policy strategy known as inflation targeting, used in many countries around the world. Inflation targeting is characterized by two features: an explicit numerical target or target range for inflation and a high degree of transparency about forecasts and policy plans.”
Bernanke’s new policy states that the Federal Reserve will double, from two to four, the number of annual forecasts it gives regarding how it sees future prospects for inflation. The “transparent” aspect of the policy is that the goals will be public, there for all to see.
But besides fighting inflation, the Federal Reserve has also been ordered by Congress to promote economic growth in order to move towards full employment. “As I have emphasized today, the Federal Reserve is legally accountable to the Congress for two objectives, maximum employment and price stability, on an equal footing. My colleagues and I strongly support the dual mandate and the equal weighting of objectives that it implies.“
But there is nothing in the new Bernanke approach that implies that one of the new goals will be enhancing “market stability”, the catchphrase codewords employed by Greenspan to ride to the rescue of the markets. Almost like a parent who deflects a child’s wish for a higher allowance by producing and displaying an overdrawn bank statement, the new policy seems to have the Fed someday telling the markets, “We’d like to cut rates, but, sorry, our rules say that we just can’t.”
It is highly questionable whether under the new policy guidelines the Fed would have cut rates the three times it has since August 17, for, by the Fed’s own admission, the overwhelming rationale for at least the first and second cuts, and a major factor in the third, was alleviating financial market turmoil.
The question now becomes, will the new policy preclude another cut at the Fed’s next meeting, on December 11? If the Cato speech represents new policy guidance then the answer is probably yes.
Inflation fears are, if anything, growing; the US dollar is plunging, and two of the bond market’s prime gauges for judging future inflationary expectations are flashing red. The spread in yield (called the “yield curve” in the markets) between what is being offered in yield by two-year and 10-year US Treasury securities is at a two and a half-year high, as is another closely watched inflation warning indicator, the “TIPS” spread between conventional fixed rate and inflation protected 10-year Treasury securities.
It also does not appear that another cut can be justified with an argument that economic growth is slowing. Third quarter US GDP growth, at 3.9%, is surprising strong; the subprime/credit crisis spooking the markets more and more with each passing day implies an economic slowdown that has not really commenced, at least not yet.
But the markets are acting as if nothing has changed with the Fed. Federal Funds futures, reacting to the continuing equity market selloffs, are still giving 94% odds of a cut at or before December 11.
On November 12, BCA Research, a prominent Montreal research organization, expressed the standard "equity market weakness equals Fed rate cuts" paradigm in this way. “Increasing stress in the financial system and signs of reduced credit availability mean that the Fed has a lot more easing ahead. The shift to a neutral bias by the FOMC was misplaced given the renewed rioting in the financial markets.”
This is thinking that the stock markets can understand, that selloffs will always be met by cuts. Unless there is an unbelievably rapid improvement in the subprime/credit picture in the four weeks before the next meeting, it will be the picture that will greet the Fed governors on December 11. If they do cut, finding a way to produce some sort of justifying blather in the accompanying post-meeting statement, right in the face of the current Fed independence bravado represented by the Cato speech, will be difficult if Bernanke is to have any credibility attached to any of his public statements for the remaining 6 years of his term.
If they disappoint the markets and fail to cut, listen for the screams of anything but joy as the stock market roller coaster takes a long, hard plunge....