Bernanke Actually Laid Out Monetary Policy in Berlin

by: Keith Lenger

Earlier in the week Fed chief Ben Bernanke gave a speech at the Bundesbank in Berlin, Germany. The vast majority of commentators dismissed it as Bernanke basically saying nothing. We're not sure what they read or heard, but we obtained a great deal of information from the Fed chief's speech. We would recommend everyone read it. (Bernanke Bundesbank Lecture) We have taken a few excerpts and placed our comments below. With the initial claims out yesterday, we still only see a 60% chance for a 25 basis point cut.

My reading of recent developments is that although some of the details have changed, the fundamental elements of the global saving glut remain in place. Most important, the emerging-market countries and oil producers remain large net suppliers of financial capital to global markets.

Translated - Rates still need to remain high to dry up excess liquidity. A slight recession in the US might not be so bad, as it would remove excess dollars flowing to oil nations and developing nations, which are often driven both by raw materials and labor.

First, these external imbalances are to a significant extent a market phenomenon and, in the case of the U.S. deficit, reflect the attractiveness of both the U.S. economy overall and the depth, liquidity, and legal safeguards associated with its capital markets.

The market may sell off, but not that bad, as there is a safety net created by foreign demand of US assets. Bernanke talked about central banks not having as large an input into these assets flows, as was previously thought. Demand would remain even if foreign central banks diversified reserves to other countries.

Second, current account imbalances can help reduce tendencies toward recession, on the one hand, or overheating and inflation, on the other.

This is a big one! The Fed for now is in favor of a low to falling dollar. However, if the economy has not slowed from the credit crunch and housing slump significantly, the Fed will move to bring rates up quickly. Look at resource prices and oil recently. The initial claims let everyone breath a sigh of relief after unemployment numbers, save for the FED. This is where we are on the fence. Will it be 25 BP or no cut?

Third, although the U.S. current account deficit is certainly not sustainable at its current level, U.S. liabilities to foreigners are not, at this point, putting an exceptionally large burden on the American economy.

Translated: We are not worried about this at all in the short term, so why should you be?

The United States and other industrial economies face the prospect of aging populations and of workforces that are growing more slowly. These trends enhance the need to save (to support future retirees) and may reduce incentives to invest (because workforces eventually will shrink).

How do you get people to save? High rates. When rates are low consumer are compelled to spend. Raise the rates and people may not be able to buy that new automobile or house because they can’t carry the financing. Where do you think the excess earnings go?

An additional brief aside about the above comment. The one thing that separates us from other industrialized nations facing the same issue is the fact that a large portion of foreigners would like to live in the US. An open immigration policy helps to lower the age of the US aggregate population and enables this larger mass to carry the burden. This is why having a protectionist border without some type of legal work program will hurt the US.

Adjustment must eventually take place, and the process of adjustment will have both real and financial consequences. For example, in the United States, the growth of export-oriented sectors such as manufacturing has been restrained by the shifts in relative prices and foreign demand associated with the U.S. trade deficit. Ultimately, the necessary reduction in the trade and current account deficits will entail shifting resources out of sectors producing non-traded goods and services to those producing tradables. The greater the needed adjustment, the more potentially disruptive and costly these shifts may be.

Isn’t this occuring before our very eyes? The dollar is dropping and demand for manufactured goods is picking up. Additionally, opening up immigration helps to lower cost of production and brings overseas production facilities back to our shores. Granted, there is a painful domestic labor shift that occurs.

What implications would a gradual re-balancing have for long-term real interest rates? The logic of the global saving glut suggests that, as the glut dissipates over the next few decades and thereby reduces the net supply of financial capital from emerging-market countries, real interest rates should rise–- a tendency that seems likely to be only partially offset by increased saving in the industrial countries… Moreover, distant one-year forward interest rates remain low, an indication that markets currently do not expect much change in the global balance of desired saving and investment or that they expect the effects of such a change to be offset by other developments. Accordingly, we are again reminded of the need to maintain appropriate humility in forecasting returns and asset prices.

This is the FED disclaimer. We read this as saying, "This is all just forecast and it’s going to take a long time for this all to transpire." Meaning that the speech has no bearing on the immediate FED rate decisions. We disagree, as it has basically laid out future monetary course.

Granted, there will be adjustments over time, but we don’t see substantially lower rates in the future. We also think the FED might be engineering a slight slow down in US economy. Similar to firefighting tactics. Let's hope this controlled burn does not get out of hand and develop into something a bit more severe.

Over the weekend, we will post a bit on how this affects our portfolio allocation.