Chairman Bernanke The Ideologue Probably Won’t Raise Anytime Soon

``A believer is a bird in a cage, a freethinker is an eagle parting the clouds with tireless wing”- Robert Green Ingersoll (1833-1899) American Statesman and Orator.

The FOMC is slated to decide on US monetary policy rates today.

Federal Reserve Chairman Ben S. Bernanke recently voiced concerns over “rising inflation” following the unexpected stance taken by European Central Bank Jean Claude Trichet declaring that the ECB may raise rates by next month to combat accelerating inflation.

As per Fed Chair Bernanke (highlight mine) “Before turning to those issues, however, I would like to provide a brief update on the outlook for the economy and policy, beginning with the prospects for growth. Despite the unwelcome rise in the unemployment rate that was reported last week, the recent incoming data, taken as a whole, have affected the outlook for economic activity and employment only modestly. Indeed, although activity during the current quarter is likely to be weak, the risk that the economy has entered a substantial downturn appears to have diminished over the past month or so. Over the remainder of 2008, the effects of monetary and fiscal stimulus, a gradual ebbing of the drag from residential construction, further progress in the repair of financial and credit markets, and still-solid demand from abroad should provide some offset to the headwinds that still face the economy. However, the ongoing contraction in the housing market and continuing increases in energy prices suggest that growth risks remain to the downside.”

Thus, Bernanke’s statement prompted for a shift in investor expectations which increased the probability that the Fed would possibly be hiking interest rates in the near future. But with the recent signs of weakness in the many economic figures/stats, the unresolved credit crisis and the softening of the equity markets this expectation have been scaled downwards.

According to Barron’s Randall W. Forsyth ``The futures markets Friday put just a 43% probability on a 2.25% fed-funds rate, up a quarter-point, at the Aug. 5 FOMC meeting, down from 83% a week earlier. Fed-funds futures also Friday priced in an 84% chance of a 2.50% by the end of the Oct. 28-29 FOMC meeting. A week earlier, the futures market thought a 2.50% funds rate was a certainty by then, with 58% chance of 2.75%.

Of course, there are many fundamental “economic” justifications why probably the Fed won’t be hiking anytime soon…

So we will leave to the institutional economists like Ms. Asha Banglore of Northern Trust who recently argued, ``First, the labor market is under severe stress, firms have stopped expanding payrolls, no ambiguity here. Second, the National Bureau of Economic Research (NBER) could take several more months to declare an official onset of a recession, but there is no doubt the U.S. economy is experiencing one. Nonfarm payrolls, one of the measures the NBER uses to date business cycles, peaked in December 2007. Third and more importantly, if history is any guide, the Fed will not raise the federal funds rate until the unemployment rate falls.” (see chart above courtesy of Northern Trust).

It is instructive to know that “jawboning” is part of the policy tools utilized by monetary authorities to shape market expectations.

This from IMF’s Atish Ghosh ``Through the signaling channel, the central bank communicates to the markets its policy intentions or private information it may have concerning the future supply of or demand for the currency (or, equivalently, the path of interest rates). A virtuous expectational cycle can emerge: for instance, if the central bank credibly communicates its belief that the exchange rate is too strong—and would be willing to change policy interest rates if necessary—then market expectations will lead to sales of the currency, weakening it as intended.”

Nonetheless on our part, we vividly remember four occasions where Chairman Bernanke defended the financial markets, particularly the stock market, as some sort of policy catechism or guideline (all highlights mine):

1. A Crash Course for Central Bankers published at foreignpolicy.com (September/October 2000)…

``There’s no denying that a collapse in stock prices today would pose serious macroeconomic challenges for the United States. Consumer spending would slow, and the U.S. economy would become less of a magnet for foreign investors. Economic growth, which in any case has recently been at unsustainable levels, would decline somewhat. History proves, however, that a smart central bank can protect the economy and the financial sector from the nastier side effects of a stock market collapse.”

2. “Never Again” speech at Milton Friedman’s 90^th birthday (November 8, 2002),

``For practical central bankers, among which I now count myself, Friedman and Schwartz's analysis leaves many lessons. What I take from their work is the idea that monetary forces, particularly if unleashed in a destabilizing direction, can be extremely powerful. The best thing that central bankers can do for the world is to avoid such crises by providing the economy with, in Milton Friedman's words, a "stable monetary background"--for example as reflected in low and stable inflation.

``Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.

3. The celebrated Helicopter speech, ``Deflation: Making Sure "It" Doesn't Happen Here” (November 21,2002 )

``But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as 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 higher spending and hence positive inflation.”

4. The Financial Accelerator speech, ``The Financial Accelerator and the Credit Channel” (June 15, 2007)

``As the topic of this conference reminds us, financial conditions may affect shorter-term economic conditions as well as the longer-term health of the economy. Notably, some evidence supports the view that changes in financial and credit conditions are important in the propagation of the business cycle, a mechanism that has been dubbed the "financial accelerator." Moreover, a fairly large literature has argued that changes in financial conditions may amplify the effects of monetary policy on the economy, the so-called credit channel of monetary-policy transmission. In fact, as I will discuss, these two ideas are essentially related. As someone who (in a former life) did research on both of these topics, I thought it might be useful for me to provide a somewhat personal overview of the financial accelerator and credit channel ideas and their common underlying logic. Along the way I will offer a few thoughts on where future research might be most productive…

``The critical idea is that the cost of funds to borrowers depends inversely on their creditworthiness, as measured by indicators such as net worth and liquidity. Endogenous changes in creditworthiness may increase the persistence and amplitude of business cycles (the financial accelerator) and strengthen the influence of monetary policy (the credit channel). As I have noted today, what has been called the bank-lending channel--the idea that banks play a special role in the transmission of monetary policy--can be integrated into this same broad logical framework, if we focus on the link between the bank's financial condition and its cost of capital. Nonbank lenders may well be subject to the same forces.

The interesting chart courtesy of Elliott Wave’s Euan Wilson shows of how Bernanke’s recent policies seems to have been directed towards the weakness of the stock market (represented by the Dow Jones Industrials) – with most of the recent initiatives coincidentally implemented at market troughs!

To sum it up, my view is that the imperative of the Bernanke doctrine calls for the principal support of the financial markets, with all other issues being secondary.

Thus, instead of an interest rate hike which signifies the conventional thinking, the likelihood- given the continuing infirmities in the equity markets- is that we may see Chairman Bernanke cutting rates instead!