FX Analytics

FX Analytics - Oct. 25 2005

In my column I mistakenly wrote that Bernanke deflation wrong footing occurred in June of 2004...it should read June 2003 when the Fed cut rates 25bps to 1.00%, the last in the cycle. The market was anticipating that the statement would more directly address deflation and it failed to...so the disappointment was more with Bernanke and Reinhart than Greenspan. Though Greenspan did over time distance himself from the deflation story and rate tightening cycle began by late June 2004.

DG (corrects text below)

The only surprising thing about President Bush naming Ben Bernanke to succeed Chairman Greenspan at the helm of the FRB was that it was not a surprise. Perhaps a low political capital meter reading, trouble with Miers nomination to the Supremes and more respect for financial markets allowed for the most logical transfer to the former Princeton University Econ Prof.



Bernanke is best known in the financial markets for his deflation campaign at the Fed that took on a tour de force in the spring of 2004. Bernanke was worried that near zero inflation and stagnant economic activity could prompt a Japan-like bout of US deflation. He managed to convince Greenspan of the risk and hence the Fed took out additional insurance against a low but unacceptable risk and cut Fed funds an additional 75bps to in part keep deflation at bay. Bernanke and a close staffer Vincent Reinhart even invited down the Street to lecture top buy and sell side traders just what the Fed could do if deflation were to occur...hence the dropping money from a helicopter saying that eventually emerged in the press. Most who went to the deflation seminars at the Fed Board were long Treasuries and upon return got even longer Treasuries. Greenspan in May also seemed to buy the Bernanke-Reinhart story on deflation when he told a Berlin audience that the Fed needed to build a firebreak around deflation. But by the summer Chairman Greenspan had abandoned Bernanke and the deflation story and began what was and still is one of the longer strings of interest rate hikes (now at 275bps). Many traders had their collective clocks cleaned on this trade and blamed Bernanke for leading them down a path of false promises. But the truth is that Greenspan wrong-footed the market and Bernanke. Still it is wrong to think that Bernanke is a dive because he worried about and advocated against deflation. What the deflation story showed is that Bernanke pays lots of attention to the price level and inflation measures generally and as an advocate of inflation targeting I think it is a safe assumption that he would be as reactive to inflation approaching the top end of the Fed's threshold as the bottom end.



What makes Bernanke better than Greenspan is his propensity for a rules-based monetary policy which by definition de-emphasizes the personal read of macro conditions by the Fed Chairman...something Greenspan has elevated beyond any of his predecessors. Bernanke is no dogmatist when it comes to rules. There will be a role for discretion (and inflation targeting would have to be approved by the Fed Board and FOMC before formally put in place...no guarantee here) on top of any inflation target however formal or informal. I also think Bernanke is much more about making Fed policy a collaborative process rather than the work of one (plus staffers, Kohn). In a democratic institution generally (branches of gvt), I have been very surprised at how undemocratic Greenspan monetary policy has become (see Larry Meyers book or listen to Alan Blinder), especially when the Chairman is appointed and not elected. The second most powerful person in the world making monetary policy decisions largely on his own (and arguably most of the time appropriately) is an anathema to American standards of government and governing institutions. Equally I think it unlikely that Bernanke will lose control to a large unwieldy body - the FOMC.



Despite being named Bush's top economist (Chairman of the Council of Economic Advisors), I think Bernanke will be more independent (from politics

generally) than Greenspan. Greenspan crossed the line by giving his backing to Bush tax cuts (unfunded ones in 2001), commenting on energy policy and seeking out Washington politicos. I tend to think Bernanke is not comfortable with this side of Washington life and public service and will stick to monetary policy and the economy when it comes to his relations with the White House and Congress. One anecdote worth noting is that Bernanke recruited Paul Krugman to join the Princeton University Econ Department when Bernanke was department Chairman. Bernanke is no ideologue (nor is Greenspan), and appears skeptical of supply side economics. If I had to pigeon-hole Bernanke, he is a neo-Keynesian.



What makes Bernanke a worse Fed Chairman than Greenspan? His lack of experience of course, but also his DNA that tells him inflation-based monetary policy is the way to go forward, which at times could make for policy inflexibility when flexibility is demanded as in financial crises. Greenspan, I believe, has a far deeper understanding of financial markets and the banking system than Bernanke could possibly have and as history has shown, market knowledge is a key asset for a Fed Chairman. Greenspan was so confident of what was best for markets that he often shaped market expectations (indirectly targeting asset prices) with his notorious use of the financial press - WSJ, Washington Post and Business Week - to get the word out. Bernanke is surely more inclined to be as open and clear about monetary policy and let the chips fall as they may with asset prices (read market expectations) than anything we are used to with Greenspan. Keep in mind I have in the past been critical of the way in which Greenspan deliberately sought to shape market expectations by speaking with the press of the record or in journalese - deep background. But it was at times effective and as a believer in market inefficiencies, more flexibility and more tools to administer policy suggests that Bernanke will not be going where Greenspan went when it comes to utilizing the financial press, and a select few at that, to guide expectations.



In theory a more rules-based monetary policy with more transparency should result in reduced asset price volatility. But nothing guarantees that a drift to inflation targeting will get it right at the end of the day. Nor do rules over discretion leave much leeway for responding to thinks like Long Term Capital, the Asian currency crisis, Y2K, Mexican peso crisis or a run on the dollar.



When Greenspan was named to replace Volcker in 1987, markets moved big time as the incoming Chairman was a relative unknown (dlr, bonds and stocks all fell). So it is no surprise that Bernanke's nomination has done little to bonds and the dollar and I suspect by the end of the week, we can add stocks to the sentence. I also think that Bernanke could step in to his first FOMC meeting in late March with a need to hike simply to show markets he has symmetry in handling upside as well as downside risks to prices. Furthermore, his remarks in the London Times today or in recent weeks and months on inflation (sees it contained to energy...not much in way of second round effects), must be seen in light of his current position...Chairman of Council of Economic Advisors and not as a Fed Chairman. Hopefully he will prove that making monetary policy can be more about the institution than the Chairman and if so this will be a breath of fresh air. Cults of personality never sit well with me and dare I say most free thinkers.



David Gilmore

FXA

www.fxa.com