In the new era of Fed transparency, Ben Bernanke has removed any ambiguity as to what the Fed's objectives, goals and actions are and will likely be going forward. In this video, Mr Bernanke clearly outlines what the financial markets can expect. The first comment he makes is to define the framework in which all Fed decisions are made. The Fed is guided by what is called their "dual mandate" of full employment and low inflation. The Fed has to balance monetary policy so that they don't drive unemployment so low that it triggers inflation, or allows unemployment to go so high that it threatens deflation. The Fed never targets zero unemployment and they never target zero inflation. Both a little unemployment and inflation are healthy for an economy. The classical relationship between inflation and unemployment is called the Phillips' Curve. Analogies are often made to Odysseus sailing between Scylla and Charybdis, where monetary policy has to sail a tight course between the two monsters of unemployment/Scylla and inflation/Charybdis. If monetary policy strays too far in one direction, the economy will be devoured in the whirlpool of unemployment or smashed upon the rocks of inflation.
Given this framework, Mr Bernanke then proceeds to outline what the market can expect with his "three stages of recovery."
Stage #1: Dependent upon unemployment and inflation approaching the 2% inflation target, the Fed will first slow, and then stop asset purchases. This is the first step towards "normalization" of monetary policy. The key here is that the Fed's decisions are data driven, so setting hard and fast deadlines are not appropriate. A timeline is not given, only the order of the stages.
Stage #2: May be a lengthy period where the Fed passively observes the economy as it slowly works its way towards the 6.5% unemployment and 2% inflation target. Mr. Bernanke made a point to state that "not before 6.5% unemployment" and that reaching those targets wouldn't automatically result in any Fed action other than an analysis on the economy and the appropriate policy at that time. This is most likely because unemployment is a very odd economic metric because of the way it is calculated. It is not unusual to see the unemployment rate increase as the economy starts to recover as "discouraged" workers return to the labor force. Current unemployment figures most likely under report the true unemployment condition of the economy due to the unusually long and slow period of recovery and historically low labor force participation rate. Because of this, I would expect the Fed to have a decent amount of patience once the unemployment rate hits the 6.5% target, and would not expect them to act unless unemployment was showing significant gains.
Stage #3: "Normalization" of the monetary policy preferably once inflation is at or above 2% and unemployment is at or below 6.5% for an extended period of time. Both objectives don't have to be met simultaneously, but I would imagine the Fed will allow a buffer around those targets and make every attempt to hold off any tightening until both objectives are met. Because long-term unemployment is most likely considered the greater threat to the economy, I would imagine the Fed will allow the 2% inflation target to be breached and accept a little more inflation in the economy than they desire if unemployment is not below 6.5%. There is a bit of subjectivity to Stage #3, but I think it is safe to say the Fed will be more concerned with fighting unemployment than inflation, at least in the early part of Stage #3. Once the Fed sees the need, it will then return to normal monetary policy of raising short-term interest rates, and selling bonds to "normalize" its balance sheet. If the recovery remains slow, this will be a very gradual process.
Mr. Bernanke stresses that nothing he has said should imply tightening anytime in the foreseeable future. It is important to understand that "tapering" is not "tightening." We are a long way away from the Federal Reserve directly increasing interest rates. Because of this, it is far more likely that the markets will increase interest rates long before the Fed, so during the later part of "normalization," the long-term interest rates may be the best way to judge when the Fed will start to raise interest rates.
One bit of confusion is the vagueness of "substantial" when used when defining improvements in the labor market. Mr Bernanke stressed that they have a 6.5% target. He also discussed that the Fed understands and analyzes the risks and benefits of QE and the resulting balance sheet expansion. He downplayed the concerns that the Fed's actions create imbalances, and explained how the balance sheet has a mechanism to unwind itself as bonds mature. I tend to agree with this because there isn't a whole lot of difference between the Fed holding a mortgage bond or an individual holding a mortgage bond during a non-inflationary environment. The risk in that situation isn't inflation, but the risk of higher interest rates, slower growth and higher unemployment if the Fed were to sell those bonds prematurely and unintentionally increase interest rates.
My favorite part of the video is at the end when Mr Bernanke takes a direct jab at my friends in the Austrian School of Economics, Ron Paul and Peter Schiff being some of the most vocal. He points out how ridiculous the "liquidation theory" of the 1930s was, and how it taught that recessions and depressions were good because they "purged the evil from the system." Those comments are sure to generate many comments from the fans of Austrian Economics, but the liquidation theory is simply wrong, and proved to be incredibly damaging in the Great Depression. The first flaw in this theory is that it assumes there is some natural base level of economic activity that the economy will fall to when there isn't. During the Great Depression, entire factories sat idle, and for over a decade, over 10% of the workforce was unemployed.
The second flaw is that it doesn't explain why or how after such devastation the economy should recover, and most dangerous of all is that inherent is this theory is the belief that deflation is good and inflation is bad. The deflation of the Great Depression was viewed by some as a positive sign, and evidence that the economy was ridding itself of "malinvestment."
This theory is unbelievably dangerous because it sounds so plausible because the reality is so counterintuitive. Nothing is more difficult than trying to explain to someone that mild inflation is good and deflation is a death sentence for an economy. People inherently think lower prices are good, and inevitably point to the technology industry. Falling prices of big screen TVs, tablets and smart phones is great because those lower prices are market driven through expanding capacity and process efficiencies. Falling TV prices isn't deflation, deflation is a decline is aggregate prices due to falling demand for a given supply. Deflation results in higher real interest rates, under water mortgages, lower wages and productivity and the inability to pay off loans made for inventory. Just imagine the gold merchants that built their inventory when gold was over $1,900/oz. -- now apply that to the entire economy. Deflation makes it impossible for even the best run businesses to function, and doesn't distinguish between malivestment and sound investment. Deflation throws the baby out with the bath water.
The other important point made at the end of the video is that interest rates aren't low because of the Federal Reserve's monetary policy, but because of the slow economy. The Fed certainly hasn't done anything to drive rates higher, but in reality the interest rates are low because the markets are pricing them low due to the very slow economic growth. That is proven by the fact that the 10 year rates recently increased from under 1.7% to over 2.7% without any change in Fed policy. The Fed puts a "price floor" in the interest rate market, not a ceiling. There is little the Fed can do to stop interest rates from increasing on their own if the market conditions justify them.
In conclusion, the take-home message for investors is that unwinding QE and monetary policy "normalization" is a slow and deliberate process. Because of this, I would not expect any spike in interest rates to be caused by the Federal Reserve, so I would expect a slow and gradual increase in long-term interest rates being driven more by market conditions than Fed policy. The other take home message is that the era of buying gold/SPDR Gold Trust (GLD) and silver/iShares Silver Trust (SLV) based upon the expectation of further episodes of QE is likely over. Each round of QE has seen its effectiveness diminished, and Mr. Bernanke mentioned that in the future they are gong to most likely rely more on rate policy than asset purchases. This recent testimony did result in a rally in gold, but it was a muted rally that failed to break $1,300. The one thing not covered in the video is the real reason for the slow economic growth, contractionary fiscal policy. There is nothing monetary policy can do to compensate for failed fiscal policy. If investors want to understand what the Fed will do, they should study the progress in fiscal policy. Fiscal policy drives monetary policy, and until Washington gets its act together, Mr. Bernanke's hands are tied, and highly accommodative monetary policy can be expected to continue.
Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.