The Fed's Fire Chief Faces Congress
In his semiannual monetary policy report before the Senate Banking Committee on Feb. 24, Federal Reserve Chairman Ben Bernanke testified that downside economic risks remained the central bank's primary focus, and that the Fed would continue to utilize "all tools at its disposal" to limit the damage. While he endorsed recent Treasury proposals, including a public-private vehicle to dispose of toxic mortgage debt, he delicately side-stepped attempts to politicize the recent fiscal stimulus package.
The Fed's concern appeared to shift to the globalization of the economic crisis, which may delay the eventual U.S. recovery. The Chairman argued for patience as the full scope of monetary and fiscal stimulus is implemented and reiterated that the Fed is prepared to purchase long-term Treasuries if that would help credit market conditions.
In a surreal moment of clarity, the Fed chief faced the critics of government support to the financial sector in the form of government stakes and subsidies that could be seen as rewarding bad behavior. He offered the analogy of a neighbor smoking in bed and setting his house on fire in a neighborhood of wooden houses. The policy options are letting that neighbor's house burn to the ground to teach him a lesson, at the risk of burning the whole neighborhood, or calling out the fire department to put the fire out.
Coordinated Rate Cut
Bernanke chose to call the fire brigade, while imposing sanctions against the neighbor to punish future reckless behavior.
In his testimony, Bernanke underscored the Fed's accommodative policy stance. "Faced with the significant deterioration in financial market conditions and a substantial worsening of the economic outlook, the Federal Open Market Committee (FOMC) continued to ease monetary policy aggressively in the final months of 2008, including a rate cut coordinated with five other major central banks. In December, the FOMC brought its target for the federal funds rate to a historically low range of 0% to .25%, where it remains today. The FOMC anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time."
The Fed chief also highlighted the headwinds to U.S. growth. "In all, U.S. real gross domestic product (GDP) declined slightly in the third quarter of 2008, and that decline steepened considerably in the fourth quarter. The sharp contraction in economic activity appears to have continued into the first quarter of 2009," Bernanke said.
Energy a Price Declines a Plus
The Fed's own "central tendency" forecasts for growth, as revealed in last week's minutes from the Jan. 27-28 meeting, were revised down by more than had been expected for 2009, with inflation-adjusted GDP contraction now pegged at -1.3% to -0.5%, vs. Action Economics' own -0.6% estimate, and the Fed's October central tendency forecast of -0.2% to 1.1% growth. The Fed projects 2.5% to 3.3% growth for 2010 and a much higher 3.8% to 5.0% central tendency for 2011.
Bernanke noted that "substantial declines in the prices of energy and other commodities last year and the growing margin of economic slack have contributed to a substantial lessening of inflation pressures. Indeed, overall consumer price inflation measured on a 12-month basis was close to zero last month. Core inflation, which excludes the direct effects of food and energy prices, also has declined significantly."
He also flagged the risks inherent in a global slowdown, which could "adversely affect U.S. exports and financial conditions to an even greater degree than currently expected." Another risk: the so-called adverse feedback loop, "in which weakening economic and financial conditions become mutually reinforcing."
Full Recovery Two Years Away
As to the timing of a rebound, "the view of policymakers is that a full recovery of the economy from the current recession is likely to take more than two or three years."
Bernanke maintained that the Fed will ultimately prevail. "In light of these developments, the Federal Reserve is committed to using all available tools to stimulate economic activity and to improve financial market functioning. Toward that end, we have reduced the target for the federal funds rate close to zero and we have established a number of programs to increase the flow of credit to key sectors of the economy. We believe that these actions, combined with the broad range of other fiscal and financial measures being put in place, will contribute to a gradual resumption of economic growth and improvement in labor market conditions in a context of low inflation."
The Q&A session with lawmakers that followed the prepared testimony was fairly complex and wide-ranging, with the topic of bank nationalizations front and center. Bernanke noted the great technical difficulty in shutting down a major bank or holding company, given its size, many components, and international position. Bernanke also said until it is "safe to close down a big bank, you have to try to avoid it." The Fed also doesn't have the authority to shut down a bank, he said. What's missing currently is a comprehensive resolution authority. Bernanke also believes major banks have significant franchise values, and when the government starts to take over, the companies lose their name value. He believes increasing transparency via stress tests, and putting the asset purchase plan in effect is feasible and will be beneficial in stabilizing the system.
Bernanke said the regulators are not proposing a bank nationalization. He characterized the aid one of the big banks might receive as a "private-public partnership," echoing the Treasury, but declined to call such aid "nationalization" as the government would not wholly own, or even be a majority owner of a bank. Bernanke also reminded lawmakers that should one of the major banks become insolvent, we have the rule of law to outline subsequent procedures. Without the Troubled Asset Relief Program (TARP) aid last fall, many big banks would have failed.
Bank Stocks Not a Buy
As to why an investor would purchase common stock in a bank today, the Fed chief answered one would not, but the appeal would resurface eventually once stability is restored.
On bank capital adequacy he acknowledged the many deficiencies and said there is more work to be done. Bernanke cited the need to think of a new regime where capital would be related more closely to the assets being held by an institution. He said there needs to be a more aggressive methodology of discovering what the risks are, and any new approach will have to address off-balance-sheet exposures that weren't adequately represented in capital ratios previously. More work needs to be done on a more comprehensive risk management scenario as well. On bank stress tests, Bernanke said that while all large banks currently meet the regulatory definition of "well-capitalized," the authorities want to ensure that the banks can meet even worse economic and financial conditions.
Addressing a more basic topic, Bernanke said the various recovery plans may go against American values of self-reliance and responsibility, but he believes it is best to put out the fire now and subsequently take the necessary steps and impose the appropriate penalties to make sure such risky behaviors don't occur again. He also believes that the Treasury's plan, if well-executed, is the "best hope" for restoring stability in the financial system.
Don't Call It "Nationalization"
Bernanke called for patience in seeing the results of the stimulus. Though the Fed chief was ambiguous on his support of the specific stimulus plan adopted, he did support the idea that the adoption of a quantitatively large stimulus plan was a reasonable choice.
In all, Bernanke had to use all his intellect and characteristic sincerity in his Feb. 24 appearance before the Senate panel to state the case for the inexorable slide into temporary public ownership of minority stakes the financial sector to help lubricate the fragile economy.
It was his evident discomfort with the word "nationalization," however, that sparked some relief in the markets, along with his view that such a drastic step is not necessary nor helpful. Maintaining some semblance of a private sector struck an optimistic chord with investors on Feb. 24, with stock indexes staging a late rally, though it should be remembered that financial events have had a way of getting ahead of policymakers during the current crisis.