Wall Street is an unforgiving place, and has the ability to defenestrate Fed Chairmen it doesn’t like – witness the sad fate of President Jimmy Carter’s Fed Chairman G. William Miller, ousted only 17 months into his 4 year term in 1979. Current Fed chairman Ben Bernanke gave a huge hostage to fortune with his optimistic Congressional testimony last week; will he by the end of 2007 have shared Miller’s fate?
Miller was a lawyer and successful industrialist, Chairman of Textron, with good Democrat connections. In early 1978, Carter had been expected to re-appoint Fed Chairman Arthur Burns to a third term in office, but did not do so, since Burns was believed to be too hawkish on inflation (given Burns’ failure to control the takeoff in inflation in 1971-74, it’s likely that the real objection was Burns’ party-line Republicanism.) Miller, a loyalist with a good reputation, seemed an attractive replacement, but gave a hostage to fortune during his 8 hour Senate confirmation hearing (most of which was devoted to alleged Textron bribes) when he flatly stated that monetary policy could not control inflation.
Since Milton Friedman and Anna Schwarz’s “A Monetary History of the United States” had been published in 1963, and their ideas were already well understood on Wall Street, Miller’s claim must be put down to his lack of technical background, combined with a natural attachment to the beliefs common in academia while he was in graduate school in the 1950s.
Throughout his short tenure, Miller remained remarkably reluctant to increase interest rates to fight inflation, believing that higher interest rates brought the danger of an unpleasant recession. The Federal Funds rate increased gradually from an average of 6.89% in Miller’s first month in office to 10.47% in his last, while 12 month trailing consumer price inflation increased from 6.5% to 11.3% — in other words, short term interest rates remained around zero in real terms, even though the dollar suffered a major foreign exchange crisis in the autumn of 1978. Little wonder, therefore that as inflation inexorably increased Wall Street lost confidence in Miller, a problem that Carter “solved” in July 1979 by nominating him as Secretary of the Treasury, thus transferring Wall Street’s distrust from monetary to fiscal policy.
Miller was replaced by the monetarist Paul Volcker, Wall Street’s candidate for the job and known to have been hawkish on interest rates throughout his term as President of the New York Fed from 1975. Volcker quickly pushed up interest rates to a point where they could do some good, inflicted the necessary recession on the U.S. economy, and solved the inflation problem.
While he lacks the depth of experience in money markets of Volcker or of his immediate predecessor Alan Greenspan, Bernanke has a stellar academic background in the subject, and has thus presumably read Friedman and Schwarz. Nevertheless, Wall Street is no fonder of academics than it is of industrialists and hence Bernanke is in more danger of an early withdrawal of confidence than were Greenspan or certainly Volcker.
Mere economic difficulties will not cause Wall Street to lose confidence in a Fed Chairman. Volcker retained its confidence (though not entirely that of even Ronald Reagan’s conservative administration) during the harsh recession of 1981-2, and Greenspan retained and even increased its confidence by his handling of the 1987 stock market crash and the 1990-91 downturn.
As well as Miller’s tenure, there is another example of Wall Street losing confidence in the Fed, the bank panic of 1932-33. While that occurred at a time of extreme economic distress, the principal rationale for panic was a belief that the Fed had lost control of the situation, and was unable to prevent even substantial and well run banks from going under. The Franklin Roosevelt “bank holiday” of March 1933 and subsequent bank regulations convinced the market that the government could resolve the situation, even if the Fed couldn’t.
From this very sparse history, it’s clear that Wall Street loses confidence in the Fed not through hard times, but through a growing belief that the Fed has lost control and that the principles by which it is operating do not correspond to the reality of a growing problem. An intense economic downturn (as in 1981-2) or a stock market crash (as in 1987) are acceptable, provided the Fed appears to be on top of things; what is not acceptable is a Fed policy that fails to address a perceived problem in the economy or the money markets.
In this respect, Bernanke has given a number of hostages to fortune. At the time of his nomination he was best known for a speech in November 2002 that warned of a potentially damaging deflation – a deflation that notably did not occur and the fear of which caused the Fed to lower interest rates far below the level of inflation. At his hearing in November 2005, he avoided making Miller’s mistakes, resorting instead to well worn platitudes about the dangers of inflation. In his semi-annual report to Congress in February, he again genuflected to the danger of inflation but announced that it “appeared to have been contained” and made much play of the Fed’s projection that “core” inflation over the next two years would run at 1¾%-2%.
Wall Street wants to believe Bernanke, indeed it would like its regard for him to grow into the adulation that Wall Street held for Greenspan in his later years, an adulation that undoubtedly nipped stock market downturns in the bud on several occasions. The stock market rallied sharply April 27 when Bernanke suggested that the Fed might pause its program of Federal Funds rate increases, then dropped again when Bernanke hinted to CNBC anchor Maria Bartiromo at a Saturday night party that he might have been misinterpreted. This week, Wall Street roared its approval by pushing the Dow up over 200 points after Bernanke outlined to Congress his belief that, even though the Fed’s February forecasts had been wrong (the “core” CPI rose at 3.6% per annum in the 3 months to June) the current rise in inflation was only temporary and would be reversed as economic growth fell back to its long term trend of around 3%.
If Wall Street can continue persuading itself that Bernanke is correct in his dismissal of inflation fears, the stock market will remain high and interest rates low, and the world’s current cheap money economic growth might continue, more or less ad infinitum. Monetarists claiming that money supply is growing too rapidly can be silenced by the simple expedient of not reporting money supply figures – the Fed ceased reporting M3 money supply (which had been growing at an uncomfortably high rate for a decade) in March. Every time a country or a borrower got into difficulties, its bankers could ease the liquidity crunch by lending it some more money or its investment bankers could solve its problem by a successful stock issue at an inflated price.
All it requires is for the official inflation statistics to report that inflation remains under control. These have been massaged in past years by such techniques as “hedonic pricing” whereby quality improvements in the tech sector are counted as price decreases, then re-weighted annually so that the tech sector’s weighting in the index is sufficient for next year’s improvements to suppress inflation again. More recently, the index’s use of house rents rather than sale prices allowed it to remain helpfully quiescent in 2001-05 as house prices took off while cheap mortgage finance depressed the rental market. Recently however this effect has worn off and rising rents have pushed up reported consumer prices; we can thus expect a campaign to remove them from price indices, or to create a new price index, satisfactorily un-inflating, on which Bernanke and Wall Street can focus.
The Federal Funds futures market, following Bernanke’s presentation to Congress, was forecasting Friday a probability of only around 30% of a further rate increase at the Federal Open Market Committee meeting August 8. With restrained inflation, accompanied by a little judicious fudging of the figures, the hope is that Wall Street can remain confident, stock prices high and interest rates quiescent until an economic slowdown (but not recession) reduces worldwide inflationary pressures and takes the heat off the Fed.
The gamble seems unlikely to come off, for a number of reasons. First, reported U.S. consumer price inflation ran at 4.3% in the last 12 months, so a Federal Funds rate of 5¼% is less than 1% in real terms even before you take account of hedonic pricing. Thus monetary policy remains loose, not tight. Given the inertia in the system, it’s likely that a Federal Funds rate of 8% (i.e. close to 4% net of inflation) would be needed to have a significant downward effect on inflation. We are not likely to get near that level with Bernanke as Fed chairman unless inflation gets markedly worse, in which case a still higher interest rate would be needed – Volcker pushed Federal Funds rates to 19.1%, after all.
Second, much of the current inflationary pressure results from international commodity prices; with the world economy continuing to expand and capacity tight, these are unlikely to ease, and the price effect of their recent rises has nowhere near worked through yet.
Third, U.S. capacity utilization was reported last week to have reached 82.4%, well above average and within striking distance of its all time high (the series, compiled since 1919, peaked at 88.8% in November 1973 and has not since risen above 85%). At these high capacity utilization levels, inefficient plant plays a larger role in production and wage demands become more inflationary (the failure of real U.S. wages to rise in this decade has been another factor suppressing reported inflation.)
Fourth, while the Internet has enabled outsourcing to be undertaken for both goods and services much more extensively than before, there are signs that the cost benefits of this may be diminishing. In particular, Chinese wage inflation is running close to 20% per annum and the renminbi has been strong against the dollar, suggesting that the favorable price effect of Chinese sourcing may be lessening.
This combination of factors suggests that over the next 12-18 months reported U.S. inflation will not simply remain above the Fed’s target of around 2% but will tend to worsen, reaching perhaps 6% by mid 2007. If the Fed pauses in its interest rate increases, so that real interest rates remain at historically low levels, Wall Street will come to regard the Bernanke Fed as responsible for the worsening inflation, and to believe that draconian interest rate rises on the Volcker model are needed. Bernanke’s optimistic statements and insouciance about inflation will be held against him, and his spurious 2002 warning about deflation will be remembered as “evidence” that he is monetarily unsound.
Once Wall Street ceases to trust Bernanke, the market effects will be severe. Interest rates will rise further than is justified by inflation, because Wall Street lacks confidence in the value of money. Stock prices, instead of rising 200 points when Bernanke issues an optimistic forecast, will decline as Wall Street denigrates “mush from the wimp.” Eventually, the economic costs of Bernanke remaining Fed Chairman will become intolerable, and he will be forced to resign.
Bernanke’s survival as Fed Chairman depends on his benign forecast of declining inflation in a moderating but still growing economy proving correct. There is a chance of this, no question. But I wouldn’t bet any money on it!
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)