Bernanke’s High-Wire Juggling Act

Fissures are developing among policy makers at the Federal Reserve as they debate how and when to start raising the benchmark interest rate from its current level just above zero.

With Fed officials forecasting that unemployment will average 9.8 percent in 2010, nobody appears to be arguing that monetary policy should be tightened anytime soon.

But Fed officials have hinted at new disagreement in recent weeks. The arguments go beyond the traditional split between hawks, who worry that easy money will stoke inflation, and doves, who contend that unemployment is the top problem.

The more devilish debates are about how fast to act once the decision has been made, and how to carry it out. Beyond raising the overnight federal funds rate, the Fed also has to unwind $2 trillion in special programs that prop up paralyzed banks and credit markets.

“When the economic outlook has improved sufficiently, we will be prepared to tighten the stance of monetary policy and eventually return our balance sheet to a more normal configuration,” Mr. Bernanke promised.

Policy makers are haunted by the results of previous miscalculations. Mr. Bernanke and others have warned that the central bank should not repeat its error in 1937, when it raised interest rates too early and helped extend the Depression for several years.

At the same time, officials at the Fed are acutely aware that it has been widely blamed for contributing to the housing bubble and the financial collapse by keeping the cost of borrowing too low for too long after the recession of 2001.

Fissures or Canyons?

Are these fissures we are discussing or canyons? Take a look at what some Fed Members are saying.

Thomas M. Hoenig, president of the Federal Reserve Bank of Kansas City: “My experience tells me that we will need to remove our very accommodative policy sooner rather than later. Even if we were to start immediately, much time would pass before incremental increases could be considered tight or even neutral policy.”

Richard Fisher, president of the Federal Reserve Bank of Dallas: "“That wind-down process needs to begin as soon as there are convincing signs that economic growth is gaining traction.”

What Does Bernanke Mean?

Bernanke’s statement “When the economic outlook has improved sufficiently, we will be prepared to tighten the stance of monetary policy and eventually return our balance sheet to a more normal configuration” is completely ambiguous because "improved sufficiently" can mean whatever he wants it to mean.

In the absence of a definition, everyone else is left guessing.

Calculated Risk discusses the above in NY Times: Divergent Fed Views and came to the conclusion that "improved sufficiently means Bernanke will wait for a meaningful decline in the unemployment rate".

I happen to agree with CR that unemployment is what Bernanke may be hinting at, but who really knows? It’s quite possible Bernanke does not know himself. It is also possible he is purposely ambiguous hoping to soothe the markets.

When Will The Fed Start Hiking?

Based on unemployment rate expectations, CR "does not expect the Fed to raise rates until late in 2010 at the earliest – and more likely sometime in 2011"

My unemployment projections are more bearish than CR’s as noted in When will the Fed start hiking?

click on chart for sharper image

Look for unemployment to rise until late 2010 at a minimum. Mid-to-late 2011 is a distinct possibility as is an unemployment rate north of 11%. Of course real unemployment is already approaching 20%.

If unemployment is Bernanke’s ticket, we might not see hikes until 2012.

However, that 2012 date assumes a lot of things: There is no treasury market revolt, unemployment stays high, a panic in the US dollar or the derivatives market does not force Bernanke’s hand earlier, and that Bernanke can retain control of the Fed. That’s a lot of assumptions for sure.

Bernanke’s Dilemma

• Bernanke wants banks to lend but not recklessly so because it will increase future writeoffs. That is an incredibly fine line to walk given the massive problems in commercial real estate, housing, and credit card portfolios in conjunction with rising unemployment, rising foreclosures, and rising bankruptcies.
   
• Although Bernanke wants banks to prudently lend, he also wants to pay banks interest on excess reserves so that the Fed can slowly recapitalize banks over time. Yet, paying interest on reserves encourages banks to not lend. Why should banks lend when risk is high and the Fed is paying them interest to sit?
   
• Bernanke wants a steep yield curve to help bank profits. However, Bernanke does not want mortgage rates to go up, which is what they would normally do if the yield curve steepens.
   
• Bernanke does not want to expand the Fed’s balance sheet anymore than he already has. However, the Fed is directly buying treasuries and agencies hoping to keep down mortgage rates in the face of a potentially steepening yield curve.
   
• Outside the US, there is universal demand for the US dollar to strengthen and the US savings rate to increase. Bernanke, the Treasury, and the Administration want the opposite. Complicating the issue, Bernanke surely does not want a disorderly decline in the US dollar because he might be forced to defend it by hiking rates. Adding to the dollar crosscurrents, talk by Fed Governors encouraging Bernanke to hike is on the surface dollar supportive, if only for a while.
   
• The Eurozone, Japan, China, the UK, and the US are all in the same boat, hoping for a weaker currency to stimulate exports. It logically cannot happen. Please see Gold And The Watched Pot Theory for further discussion of this balance of trade problem the G-7 and G-20 refused to address.

Crosscurrents Many, Solutions Zero

One thing all the central banks have in common during any crisis is they all want to buy time.

With that in mind, one might even wonder if the statements by Bernanke and the other Fed members are nothing more than an attempt to appease both the hawks and the doves simultaneously via conflicting and/or ambiguous signals, hoping to buy time.

Regardless of what they are trying to do (if indeed they even know), Bernanke in particular, and central banks in general are clearly juggling a lot of balls. In light of global and domestic crosscurrents, it is questionable how much longer this high-wire juggling act can last.

Mike "Mish" Shedlock

Crossroads