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By William Patalon III
And Mike Caggeso
Money Morning News Analysis
Fed Chairman Ben S. Bernanke has taken a lot of heat for his apparent unwillingness to launch a pre-emptive strike on an economic downturn by slashing short-term interest rates – and the sooner the better.
In fact, Bernanke has probably gotten more advice this month on how to do his job than in any of the other 18 months that he's been on the job as the head of the nation's central bank.
And that's not going to change anytime soon.
Clamoring for a Cut
The drumbeat from Wall Street is almost deafening. Bloomberg News has accused him of making a "rookie mistake," reports best-selling author and noted finance theorist Jeremy Siegel of the University of Pennsylvania's Wharton Business School. Indeed, Siegel reports that one of the most-watched videos on YouTube is that of a tirade by "Cramer" (let's face it, CNBC's Jim Cramer has reached the point – at least in financial circles – where he can be referred to by a single moniker, much like Prince or Madonna in music) in which he claims Fed policymakers "are nuts!" and "know nothing."
There's only one problem with what all these folks are saying.
With the exception of Wharton's Siegel, they're all wrong.
Bernanke may be a rookie, but this was no rookie mistake he made here. Don't get us wrong Ââ€” we're investors, too. And sure we'd love to see a nice fat rate reduction right now, one that would send the Dow chugging right back up that steep grade with a resolve reminiscent of The Little Engine That Could.
But we're veterans of the investing milieu. Therefore, we know it's the "long run" that really matters, for that's where the real profits are made. And it's the "long run" that veteran investors should be focusing on. Viewed from that vantage point, it's clear to us that Bernanke & Co. is making All The Right Moves.
Speculators: Do Not Pass Go
To really understand just what we mean, let's travel back in time a bit, to Friday, and take a closer look at the comments Bernanke made during the Kansas City Fed's annual economic symposium in Jackson Hole, Wyoming.
Now, we'll admit that some of his commentary consisted of the typically opaque Fedspeak. But, on one point, Bernanke was perfectly clear. If he's going to cut interest rates, it won't be to bail out the speculative players â€” the mortgage lenders, the investment banks and the hedge funds that created this mess with their ill-advised lending policies and then perpetuated it by securitizing these nasty little time bombs and allowing them to spread across the global economy like the Black Plague.
"It is not the responsibility of the Federal Reserve â€” nor would it be appropriate â€” to protect lenders and investors from the consequences of their financial decisions," Bernanke told his audience according to a Bloomberg News report. "But the developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account."
In other words, the Fed won't bail out the speculators; but it will take steps to make sure that the "real" economy doesn't slide into a downturn because of the credit crunch that's grown out of the subprime-mortgage meltdown. And that's an entirely appropriate stance.
Volcker the Visionary
Before the credit market disarray, Bernanke's chief reason to adjust rates (or leave them alone) was inflation. Standard-operating procedure calls for the Fed to raise rates in the face of an economic advance, ostensibly to keep inflation from taking hold. Conversely, when a sagging economy threatens to weigh heavily on employment and wages, the Fed typically cuts interest rates to maintain the economy's advance, or to jump-start activity if it has already slipped.
That's a vast oversimplification of what's a very complex process, to be sure. But Bernanke & Co. clearly takes its mandate as an inflation hawk very seriously. And history is an excellent reminder of just why that's so.
Just look at the central bank's years under the stewardship of Fed Chairman Paul A. Volcker (August 1979 to August 1987), perhaps the most economically painful stretch of any central bank chief in recent history. Volcker's time at the helm demonstrates how difficult it is to eradicate inflation, once that insidious spiraling of prices takes hold. It was Volcker who finally eradicated the "stagflation" of the latter 1970s [the combination of high unemployment and high inflation, a deadly one-two punch that, until it manifested itself, was thought to be impossible], which included an inflation rate that topped out at nearly 14%. To break the back of stagflation, Volcker took aggressive steps â€” including limiting money supply growth â€” that saw the Federal Funds rate peak at a whopping 20% in June 1981 [for some perspective, it had averaged 11.2% in 1979], while the prime rate soared to a staggering 21.5%. U.S. Treasury Bills hit 17.3%, and the long bond soared to more than 15%.
But as Bernanke was speaking Friday, Reuters reported that July inflation was under control, even though the U.S. economy grew at a 4% clip in the second quarter. The index of Personal Consumption Expenditures (or PCE, the Fed's chosen bellwether of inflation) rose 0.1% in July, to the prior month. In June, the index increased by 0.2%.
While it's good news for the economy â€” at least on a directional basis â€” Bernanke wants to make sure that inflation is not a problem before he cuts short-term interest rates. Our hope is that Wall Street doesn't look at these numbers, feel emboldened, and start increasing their calls for interest-rate reduction â€” to some extent, taking a playing card away from Bernanke. He's been saying he's chiefly concerned about the whole economy â€” which is tugged north by inflation, and pulled south by the credit crunch. And this only gives more reason for his critics to call on him to cut the benchmark Federal Funds interest rate, which has stood at 5.25% for the past nine Federal Open Market Committee (FOMC) meetings.
In response to the growing global credit crisis, the Fed already cut the Discount Rate, the rate that the central bank charges member banks for loans so that they can maintain adequate loan reserves, and has joined other countries' central banks in injecting capital into the economy to maintain liquidity.
But the clamoring we've been hearing is for the central bank to cut the Federal Funds rate, the short-term rate that has an immediate impact on borrowing costs throughout the U.S. economy. Invariably, on days that the Fed announces a change in the Fed Funds rate, major banks will follow suit late that same afternoon, moving in lockstep, and boosting or reducing the Prime Rate by the same amount.
[The Prime Rate, as you know, is the base rate that banks use in calculating commercial-loan rates to their best and most-creditworthy customers. Most other consumer-oriented lending rates are then calculated based on the existing prime rate.]
Because it also so quickly affects market rates, Bernanke wants to avoid cutting the Fed Funds rate in response to anything other than a signal by the economy that such a reduction is warranted. The cut in the Discount Rate and the liquidity injections kept the tight credit markets from seizing up, but didn't bail out the speculative malefactors. It was a wholly appropriate move.
There's a second consideration â€” stoking an economy that doesn't need the boost. If anything here â€” in an odd bit of irony â€” Bernanke is taking great care to learn from one of the rare mistakes of his predecessor, former Fed Chairman Alan Greenspan, the person Wall Street now wants Bernanke to emulate.
Without the big institutional investors even realizing it, Bernanke is actually giving "The Street" just what it wants.
Shades of â€˜98
Back in 1998, Greenspan faced a situation not very different from the one that his success forces now, Money Morning Investment director Horacio Marquez recalled recently. Obviously, Bernanke's crisis is the subprime-induced credit crunch. But Greenspans' was the implosion of the Long-Term Capital Management hedge fund. After Russia defaulted on its domestic GKO [Gosudarstvennoe Kratkosrochnoe Obyazatelstvos] bonds, an overleveraged LTCM â€” and a number of other speculators â€” were essentially forced to dump big chunks of their assets. There was a steep market sell-off â€” not to mention lots of worried talk about economic downturns, outright recessions, or a worldwide financial crisis fueled by some financial instruments that the investing masses understood very little about. Those financial instruments were called "derivatives."
The Greenspan-led Fed made its move, cutting interest rates twice successively, and "fixing" the problem in one fell swoop. But, as Marquez recounted in a recent Money Morning essay, the so-called "law of unintended consequences came into play.
The U.S. economy grew at an 8% clip in the last quarter of 2000, driving already-overvalued tech stocks into the stratosphere, and laying the foundation for the dot-com boom â€” and subsequent bust. It also fueled credit binges at both the corporate and consumer levels, helping to exacerbate the downturn of 2002 and 2003.
Indeed, in an even more ironic scenario, it's even possible that the drastic easing of credit at that inopportune time back then set the table for the real estate bubble that Bernanke is know dealing with.
Bernanke looks like he's trying very hard to avoid making that same error. The Bernanke Fed is clearly reluctant to overreact and potentially create another bubble â€” and won't easily opt to "bail out" reckless speculators, blind-to-risk borrowers, and super-aggressive/reckless lenders. Instead, the Fed first made sure to take adequate steps to make sure there was sufficient market liquidity, and will analyze the situation further from there.
No Retreat, No Surrender
As Marquez wrote back then: "It is not the central bank's job to rescue banks, or bail out investors who made ill-advised choices. Instead, its chief mandate is, first, to battle inflation wherever, and whenever, it appears; and, second, to remain vigilant against major drop-offs in economic growth."
The bottom line: Bernanke and his crew at the Fed have, thus far, shown some real restraint in dealing with this growing global credit crisis.
Interestingly, if he gave in now, and slashed rates, only to have it end up as an obvious strategic error, the move would cost him long-term credibility with Wall Street â€” even though he was making the moves Wall Street wanted. Greenspan had years of credibility built up with Wall Street and investors – to the point that he was viewed as infallible. Bernanke does not have that luxury. But by hanging tough, and doing what he believes to be the right thing, over time he'll get there.
It's the right strategy. The Bernanke naysayers have got it wrong.
But his vagueness related to his current thinking regarding an interest-rate reduction (including if and when he and the other Fed policymakers will make one), is shrewd, for it gives him time to react to the evolving situation.
But, as we noted earlier, until he actually makes the move Wall Street wants â€” if he makes that moveâ€”he can expect to keep getting pointers on how to do his job.
William (Bill) Patalon III is the Managing Editor and Senior Research Analyst for Money Morning, and is also the Managing Editor for The Money Map Report. The co-author of "Contrarian Investing: How to Buy and Sell When Others Won't and Make Money Doing it," Patalon is an award-winning journalist with 22 years experience that included stints with Gannett Co. Inc. and The Baltimore Sun. He has an MBA in finance from the Rochester Institute of Technology.
Related News and Story Links:
- Yahoo Finance News: Why Bernanke's Critics Have it All Wrong, By Jeremy Siegel.
- Money Morning News Analysis: Fed Chief Keeps His Options Open.
- Bloomberg News: Bernanke's `Rookie Mistake' Forces Fed to Shift Focus.
- Book: Stocks For the Long Run, by Wharton Prof. Jeremy Siegel [New 4th Edition, Containing Major Additions Focusing on Globalization and International Investing, Due Out Nov. 30].
- Book: Contrarian Investing: How to Buy and Sell When Others Won't and Make Money Doing It (1998).
- Money Morning Investment Report: The Three Simple Secrets to Global Investing Profits [Note Major Discussion of Prof. Siegel's Thoughts and Strategies Toward the Report's Concluding Passage].
- Wikipedia Article: The Black Plague, or The Black Death.
- Wikipedia Article: Paul A. Volcker.
- Buyandhold.com: Paul A. Volcker, Part II.
- Reuters: Inflation in Check in July But August Outlook Weaker.
- Money Morning News Report: Fed Cuts Discount Rate; Stocks Rebound.
- Money Morning News Analysis: The Fed Has Learned Balance, as it Aids Market Recovery.
- Wikipedia Article: Long-Term Capital Management.
- Wikipedia Article: Russian Financial Crisis.
- The Rochester Institute of Technology: The E. Philip Saunders College of Business.
About the Author
Before he moved into the investment-research business in 2005, William (Bill) Patalon III spent 22 years as an award-winning financial reporter, columnist, and editor. Today he is the Executive Editor and Senior Research Analyst for Money Morning. With his latest project, Private Briefing, Bill takes you "behind the scenes" of his established investment news website for a closer look at the action. Members get all the expert analysis and exclusive scoops he can't publish... and some of the most valuable picks that turn up in Bill's closed-door sessions with editors and experts.