BERNANKE´S NON-EXIT STRATEGY / BARRON´S ( RECOMMENDED READING )

Tuesday, July 21, 2009

UP AND DOWN WALL STREET DAILY

Bernanke's Non-Exit Strategy

By RANDALL W. FORSYTH


The Fed chairman's campaign for reappointment is the backdrop for his Congressional testimony this week.

IT IS MORE THAN A LITTLE IRONIC that the main topic in what could turn out be Ben Bernanke's final Monetary Report to Congress this week may be exit strategy.

Not necessarily his, but certainly that of the Federal Reserve from its extraordinary campaign to fight the most serious crisis in the financial system since the 1930s.

Bernanke's term as Fed chairman will be finished by the time the next semiannual ritual once known as "Humphrey-Hawkins" testimony rolls around again next February. Odds favor his reappointment but it's anything but a sure thing.

It's unlikely Bernanke's future will be discussed out loud but it will remain the unspoken subtext in the hearings. How the Fed chairman handles an increasingly hostile Congress may figure in his chances for another four-year term.

As usual, Bernanke will present the same testimony to both the House Financial Service Committee and the Senate Banking Committee, with the House panel leading off Tuesday morning. Much of the mystery about the Fed's outlook for the economy was taken away by the release last week of the minutes of late June Federal Open Market Committee meeting.

The policy-setting panel said it expected the recession to end "before long" but saw a tepid recovery with real gross domestic product growth of just 2% before picking up to 4% in 2011. Deep recessions usually lead to sharp recoveries, but not this time. Unemployment is expected to range between 9.8% and 10.1% in 2010, up from the current 9.5% jobless rate.

Nevertheless, the FOMC minutes showed no inclination to extend or expand the Fed's securities-purchase program, including $300 billion of Treasuries, which has caused considerable consternation even though it is dwarfed by the central bank's plan to add $1.45 billion of agency and mortgage-related securities to its balance sheet.

"While most members did not see large-scale purchases of Treasury securities as likely to be a source of inflation pressures given the weak economic outlook, public concern about monetization could have adverse implications for inflation expectations," the FOMC minutes indicated.

The unwinding of the Fed's so-called quantitative easing program is likely to be a question from the Congressional inquisitors for Bernanke. Most of them have no idea what it entails, but the notion of "printing money" to pay for the federal government deficit sticks in the craw of many of their constituents.

In truth, it's doubtful that many of them have the faintest idea of monetary mechanics, but they know that the doubling of the Fed's balance sheet sounds scary (even though it has been shrinking lately.) And even a skilled economics professor and textbook author as Bernanke isn't likely to do much to correct that ignorance.

Simply put, the expansion of the Fed's assets has not created nearly as much money as usual because banks are sitting on the reserves and not lending them. (That's called a collapse in the money multiplier for you economics students out there.) And the money supply expansion has not translated into a similar growth in the economy because it's not being spent. (That's because of a plunge in velocity, students.)

It's akin to an automobile where the engine is revving but the transmission is slipping and the tires are spinning. Once the transmission and the tires gain traction, the driver will have to ease off the accelerator or even step on the brakes not to lose control. But that's a ways off and the Fed says it's wary of the danger.

Bernanke, the entire Fed, the Obama Administration, every member of Congress and all Americans should jump for joy for the day when the monetary authorities have to tap the brakes. That's because housing, employment and output would be in an upward swing, an outcome devoutly wished by all.

But Bernanke knows the risk of braking too soon. That's what happened in 1937, which fiscal and monetary policies both tightened, in part of misplaced fear of inflation. That set the stage of the second leg of the Great Depression that followed growth from 1933 to 1936 that averaged over 9%, but still left unemployment well in double digits.

Bernanke also isn't apt to be treated with the deference that Fed chairmen are used to. That's evident from the grilling he and former Treasury Secretary Hank Paulson got from Congress regarding Bank of America's acquisition of Merrill Lynch last year.

While both Bernanke and Paulson successfully parried the queries about allegations that B of A chief executive Ken Lewis was threatened with sacking if he tried to back out of the Merrill deal, the questions may come up again, especially in the House panel's hearings.

Bernanke's ability to deal with his Congressional inquisitors over the Fed's handling of all aspects of the credit crisis will count in his reappointment campaign. And make no mistake he is conducting a very public one, unprecedented for a Fed chairman.

Following up his interview on "60 Minutes" a few months ago, something no Fed head had ever done, Bernanke will hold a "town meeting" at the Kansas City Fed July 26, highlights of which will be broadcast on PBS.

It is ironic that when Bernanke came to the Fed, he favored making the chairman less of a celebrity and base monetary policy mainly on rules rather than discretion. Now he's working hard to keep that job.

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