Thursday, November 1, 2007

Should We Be Worried About Bernanke?

Those are the ominous words of Andrew Busch in his newsletter yesterday afternoon.

I can't recall a time ever when stock prices were at all time highs, GDP was near 4.0%, and the US dollar was making all time lows....and the Federal Reserve cutting interest rates. I think I've underestimated the inexperience of the Bernanke Fed. The FOMC stands on a Jim Cramer induced precipice and risks losing the hard won Greenspan credibility.

He raises some interesting points and frankly I have to agree with him. Ever since Alan Greenspan fixated himself with the internet bubble to disastrous results, I am weary of any Fed Chairman paying too much attention to one industry. It is clear that Bernanke is focused on resolving the credit crisis in the housing market. It appears that he is ignoring the health of the overall economy. The end result of this could be disastrous.

The treasuries have responded to this latest move the same way they responded before. They traded down initially though they have come back this morning. The reason is for this is that traders see all of this rate cutting as inflationary. Here is how the USA Today analyzed his previous rate drop.
Treasury bonds were mostly lower Monday, sending yields higher, as investors focused on the prospect that last week's sharp cut in U.S. interest rates will result in spiraling inflation.


The stock market has focused on the positive implication that less expensive money will stimulate growth, while the Treasury market has fretted over inflation. Cheapening the cost of money tends to tempt sellers to lift prices, setting off inflation, which the Treasury market detests.

The reality is that most likely the best move for the Fed Chair to make is no move at all. The economy is humming along nicely. The only thing that rate cuts may do is overheat it. Bernanke is fairly new in his position and this maybe where his inexperience comes into play. Sometimes the most difficult move to make is no move at all.
This brings me back to my original point. Whenever a Fed Chairman focuses on one industry while ignoring the economy as a whole it leads to disastrous results. First, the problems in the housing market are too broad and deep to be solved simply by easing credit. Right now, we have people in homes that they simply cannot afford. Furthermore, the amount they own on their homes is probably more, a lot more, than what it is worth. This phenomenon is not something that can be solved simply by extending more credit. These people are in over their heads and they can't get out. This is not something that extending credit will resolve.

So what does Bernanke do? He lowers rates, and thus eases access to money, at a time when our economy is not only heating but on the verge of over heating. As Busch pointed out, he lowered the Funds rate on the same day that the GDP numbers came out. The latest GDP figures have the economy growing at 3.9%.

The magic number for GDP growth is 3%. Anything more and we worry about inflation and anything less and we worry about recessions. With GDP growing at 3.9%, the last thing the Fed Chairman should be doing is lowering rates. Lowering rates pumps more money into the economy and expands it even further. This puts extra inflationary pressure on an economy that already has several pre cursors to high inflation: strong GDP, strong job growth, strong stock market, and weak dollar. The genius of Greenspan throughout the nineties was managing the entire economy so that it never got too hot or too cold.
This latest move by Bernanke says that he is clearly ignoring the numbers on the overall economy and is fixated on one industry. That, frankly, is not in his job description, and is exactly the sort of hubris that I believe got Greenspan in trouble at the end of the nineties. If Bernanke continues to fixate on the housing market while continuing to ignore the economy as a whole, our economy WILL get overheated, and we WILL be dealing with out of control inflation. All of it will happen totally unnecessarily.

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