Bernanke’s Speech

Chairman Bernanke spoke today at the Kansas City Fed’s annual monetary conference in Jackson Hole, Wyoming. The speech wasn’t televised so those who wanted to follow his words had to do the old fashion thing and read his speech. Here are some highlights (italics), followed by my comments.

“At best, though, fiscal impetus and the inventory cycle can drive recovery only temporarily. For a sustained expansion to take hold, growth in private final demand-- notably, consumer spending and business fixed investment--must ultimately take the lead. On the whole, in the United States, that critical handoff appears to be under way.”

I agree that real demand will be the only thing that can lead the economy toward a long-term trend of growth, but the fiscal side is showing no sign of reversing. Excessive meddling by lawmakers has created an uncertain environment keeping stockpiles of cash on the sideline and fiscal constraint is no more than a talking point in a speech right now. The elections in November may result in a regime change, but true actions, and in turn results, are likely a ways off.

“Household finances and attitudes also bear heavily on the housing market, which has generally remained depressed. In particular, home sales dropped sharply following the recent expiration of the homebuyers’ tax credit. Going forward, improved affordability--the result of lower house prices and record-low mortgage rates--should boost the demand for housing.”

And then what? Rates are low but it took a direct cash subsidy to homeowners to get a slight uptick in home sales data, only for the same data to set new lows as soon as the program ended. I admit you can’t drastically change the way housing finance is done right now. Fannie, Freddie and Ginnie account for 95% of MBS issuance right now, but they are not the long term solution. With a natural equilibrium in home prices a normal market cannot function. Low rates haven’t helped home prices yet, and they won’t help in the future. Employment is the only long-term solution and that will take time.

“The Federal Reserve’s purchases of longer- term securities affect financial conditions by changing the quantity and mix of financial assets held by the public. Specifically, the Fed’s strategy relies on the presumption that different financial assets are not perfect substitutes in investors’ portfolios, so that changes in the net supply of an asset available to investors affect its yield and those of broadly similar assets. Thus, our purchases of Treasury, agency debt, and agency MBS likely both reduced the yields on those securities and also pushed investors into holding other assets with similar characteristics, such as credit risk and duration. For example, some investors who sold MBS to the Fed may have replaced them in their portfolios with longer-term, high-quality corporate bonds, depressing the yields on those assets as well.”

Sound familiar? Bubbles are created when investors neglect to correctly perceive risk. When the Fed drives investors out of safer asset classes into riskier ones, sorry Chairman Bernanke “longer-term corporate bonds” are not as safe as agency MBS, it causes riskier assets to be mispriced and capital to be misallocated. It happened while the housing bubble and investors were caught off guard. This all just sounds so dangerously familiar.

“A rather different type of policy option, which has been proposed by a number of economists, would have the Committee increase its medium-term inflation goals above levels consistent with price stability. I see no support for this option on the FOMC. Conceivably, such a step might make sense in a situation in which a prolonged period of deflation had greatly weakened the confidence of the public in the ability of the central bank to achieve price stability, so that drastic measures were required to shift expectations. Also, in such a situation, higher inflation for a time, by compensating for the prior period of deflation, could help return the price level to what was expected by people who signed long-term contracts, such as debt contracts, before the deflation began. However, such a strategy is inappropriate for the United States in current circumstances.”

I agree with the Chairman here. Despite inflation being significantly below trend, a target higher than a level consistent with price stability would do more harm than good right now. The Fed is deep into unchartered territory when it comes to asset purchases already, and would be better off letting the plans already put in place simply run their course.

Have a great weekend.