Bond Market Sleepwalks After Bernanke’s Downers: Caroline Baum

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Feb. 16 (Bloomberg) -- Ben S. Bernanke, Chairman Board of Governors of the Federal Reserve System 20th St. and Constitution Ave. N.W. Washington DC 20551

Dear Ben:

I hope it’s OK if I call you Ben. No disrespect intended. It’s just that I spend so much time with you -- at least thinking about you -- it feels as if we are friends. By all means, call me Caroline.

Ever since you announced last month that you were pushing back D-Day for the funds rate to the end of 2014, I’ve been scratching my head trying to figure out what you are up to.

Until that point, while I may not have agreed with everything you did to address the “unusual and exigent circumstances” confronting the economy, at least I knew where you were coming from.

Now I’m flummoxed. In recent public statements and testimonies, you went out of your way to accentuate the negative. You threw a wet blanket on improvements in the labor market. You even implied that additional quantitative easing may be necessary -- to prevent inflation from falling below the Fed’s target of 2 percent! I don’t think I’m alone in saying that deflation doesn’t appear to be a clear and present danger.

Dueling Mandates?

I understand the Fed operates under a dual mandate from Congress, charged with maintaining stable prices and maximum employment. I also understand your concern about elevated long-term unemployment, about the lives and livelihoods destroyed by the lack of a job or the skills to find a new one in today’s economy.

What I don’t understand is your strategy. The economy is slowly improving. Employers are hiring, and the jobless rate has fallen to a three-year low. Manufacturing is humming. An oil-and-gas boom is boosting big swaths of the U.S., with spillover effects on non-energy-producing areas that cater to the boom towns popping up everywhere from North Dakota to Pennsylvania to Texas.

Yet you seem to think the emergency policy setting of near-zero interest rates is still warranted. Why?

I’m surprised you haven’t been encouraged by the rebound in bank lending. Bank credit increased for the eighth consecutive month in January following three years of almost monthly declines. Isn’t that a sign that your money printing is starting to bear fruit? Why would you want to do more QE now?

It sure sounds as if you and the majority of your policy committee expect inflation, which increased 2.4 percent last year, to slow because unemployment is still high. That excess-slack argument didn’t work so well in the 1970s. Why would you rely on it now?

And whatever happened to the central-banker mantra that price stability is both an end in itself and a means to an end (full employment)? We haven’t heard that one in a while. I suspect it’s because lawmakers are more interested in creating and saving jobs, especially their own, than in hearing some economic theory about how things will play out in the long run.

And another thing. It seems as if you laid out a path for the funds rate first and then retrofitted the economic forecast to it. Isn’t that backward?

Not that the Fed forecasts have been all that great. Like many private forecasters, the Fed was totally in the dark about the degree of froth in the housing market until the bad loans almost brought down the entire financial system. And as a bank regulator, you had a big advantage over the rest of us.

Fed in Denial

I know you believe you can manage expectations when it comes to inflation and future interest rates. And it sure looks as if you’ve anesthetized the bond market with both words and deeds. The short end of the yield curve has been pinned down by your funds-rate projections while the long end has been forced down by your purchases. The Fed has gobbled up most of the Treasury’s long-term issuance since October. Why would you want to distort the shape of the yield curve, a leading indicator providing vital information about the economy?

Besides, in managing the market’s expectations you may be depressing business’s animal spirits.

No one envies the predicament you inherited from your predecessor. (I know how popular the blame game is on Pennsylvania Avenue!) What troubles me most of all, Ben, is the possibility -- nay, the likelihood -- of another massive misallocation of capital as a result of your interest-rate policies. If your projections are correct, the U.S. will have experienced six years of zero interest rates -- and, assuming no deflation, negative real rates.

The Fed has never acknowledged the key role its loose-money policies from 2003 to 2005 played in inflating the housing bubble. Why, I don’t know. The surge in the volume of adjustable-rate mortgages with all kinds of exotic -- and deadly, as it turned out -- properties is pretty convincing evidence that interest rates were a factor. Why would you want to risk this kind of outcome again?

Back in 2002, on the occasion of Milton Friedman’s 90th birthday, you took responsibility for the errors the Fed made during the Great Depression and promised not to repeat them.

I’m no Friedman, but I’d like to hear a promise from you. To the extent that the housing and credit bubbles were the proximate cause of the recession and financial crisis, will you promise not to do it again?

With fondest regards,


(Caroline Baum, author of “Just What I Said,” is a Bloomberg View columnist. The opinions expressed are her own.)

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