What Lies Ahead for Bernanke's Fed

The Fed has entered a period of policy uncertainty as it seeks to strike a difficult balance between concerns about inflation and the economy. Expect a watchful eye on potential rising labor costs, any pass-through of higher energy costs, and pricing fallout from high capacity utilization. And expect the central bank to monitor closely the housing sector for any signs it may become a drag on the overall economy.

Mortgage Banking

April 2006

By Robert Stowe England

With a new captain at the helm of monetary policy, the Federal Reserve appears to have just about completed its steady-as-she-goes journey back to policy neutrality; that is, a policy aimed at neither accommodating nor restraining the pace of economic activity. The course was set under former Fed Chairman Alan Greenspan in June 2004, when the target for the federal funds rate was only a tiny 1%, a rate level that is a strong economic stimulus. For most of that journey the inflation data have left the Fed room to proceed at a deliberate pace along a course to its stated goal, allowing it to tighten slowly.

Now, however, having arrived close to a policy of neutrality, the Fed’s task becomes more complicated and the direction more uncertain, according to Fed Chairman Ben S. Bernanke, who identified two key inflation concerns in his first testimony before Congress on February 16. One concern is that higher energy prices may pass through into the non-energy sector or, due to its persistence, push up inflation expectations. Another concern is that the economy is operating at a high level of capacity utilization, which creates a condition where demand can drive up costs. As Bernanke explained to Congress on February 15, “The risk exists that, with aggregate demand exhibiting considerable momentum, output could overshoot its sustainable path, leading ultimately – in the absence of countervailing monetary policy action – to further upward pressure on inflation.” This is one of the key reasons why on January 31st the Federal Open Market Committee, after supporting a quarter-point increase to a 4.5% federal funds rate, indicated in a statement that “a firming of monetary policy may be necessary – an assessment with which I concur,” Bernanke said.


There are also countervailing economic forces that could take some of the steam out of the strong economy, Bernanke told Congress. For one thing, he said, higher energy prices may hurt consumer confidence as it did in the aftermath of Hurricanes Katrina and Rita last year. The Fed will be keeping a close watch on the housing sector, too. While the chairman expects that the housing sector will add to overall demand this year, despite the slowdown in activity and home price appreciation, there is some risk the sector’s performance could become a net drag on the economy. “[G]iven the substantial gains in house prices and the high levels of home construction activity over the past several years, prices and construction could decelerate more rapidly than is now anticipated,” Bernanke said.


Recognizing that “substantial progress” has been made in removing monetary accommodation, decisions at the FOMC “will become increasingly dependent on incoming data” – data that Bernanke said do not always capture exactly what is occurring in the economy and with inflation. Indeed, a constant and careful review of all sorts of financial market and economic data does not quickly or easily reveal what is occurring or what monetary policy course should be followed. Going forward, “the FOMC will have to make ongoing, provisional judgments about the risks to both inflation and growth” and adjust monetary policy accordingly, Bernanke said.


Indeed, “[m]onetary policy makers must therefore strike a difficult balance – conducting rigorous analysis formed by sound economic theory and empirical methods while keeping an open mind about the many factors, including myriad global influences, at play in a dynamic modern economy like that of the United States,” Bernanke said.


In effect, monetary policy makers will have to be alert and nimble at a time when policy can shift to coast (no rate increases), brake (more rate increases) or accelerate (rate decreases). And, when choosing a course, the Fed should give “due weight to the potential risks and associated costs to the economy should those judgments turn out to be wrong,” Bernanke said.


The new Fed chairman has emphasized continuity with the policies of the Greenspan era, both in his confirmation testimony and his subsequent statements to Congress in February. Even though the Fed enters a new period of uncertainty where it will have to engage in a difficult balancing act, the timing of the change of the guard may turn out to be propitious “Bernanke made be the lucky recipient of a soft landing while keeping inflation in check. This will let Bernanke off the hook for awhile, and he will have time to get acclimated,” says David M. Jones, according to David M. Jones, Chairman of Investor Security Trust Company of Ft. Myers, Florida and President & CEO of DNJ Advisors LLC in Denver, Colorado.


Bernanke comes to the Fed with impressive credentials and is highly regarded as an economist. The former chairman of the economics department at Princeton University, he served as a member of the Board of Governors of the Fed from 2002 to 2005. Just prior to being named chairman, he was the Chairman of the Council of Economic Advisors. The winner of the South Carolina state spelling bee at the age of 11, Bernanke is best known academically for his research on the role of the Fed and monetary policy in the helping to cause and prolong the Great Depression. While a member of the Fed’s board, Bernanke warned of the considerable dangers of deflation at a time when core inflation was falling to one percent, and advised Fed watchers that the FOMC has ample tools to fight deflation even if the target for the federal funds rate fell to zero.


While his academic credentials are impressive, Bernanke’s experience in government is thin when compared to those who preceded him, according to William Niskanen, Chairman of the Cato Institute and Chairman of the Council of Economic Advisors under President Reagan. The previous two chairmen – Alan Greenspan and Paul Volcker – had a lot of experience in government before taking charge of the Fed, he adds. “There’s no reason to think he has superior political judgment on how to deal with the President, Congress and the press. He’s likely to learn it on the job, but likely to learn from his mistakes,” Niskanen says. Political judgment is crucial, he adds, especially when dealing with Congress whose members “are prone to interfere,” he adds. Bernanke may also want to take a cue from Greenspan whose statements often left those listening baffled. Niskanen says he once teased the former Chairman by saying, “You must have gone to mumbling school” in order to avoid answering a particular question or acknowledging he did not know the answer. “Bernanke will have to learn when and how to answer questions,” says Niskanen. And, to know that sometimes “it is important to avoid answering some questions entirely,” he adds.


Inflation Targeting


How will the Bernanke Fed differ from the Greenspan Fed? The most consistent response from economists is that Bernanke is likely to make an effort to have the Fed embrace an explicit numerical inflation target. “Ben is identified with supporting an inflation rule, but it is not clear what he means by that,” says Niskanen. There are a number of exceptions when one would not want to follow inflation targeting – such as providing liquidity during a time of crisis in banking or financial markets, he adds.


If the Fed set an inflation target it would be a departure from the Greenspan era. The former Fed chairman spoke more generally about keeping inflation within a narrow range but never identified a numerical range. “Greenspan’s policy was kind of mysterious and not explicit,” says Laurence H. White, the F. A. Hayek Professor of Economics at the University of Missouri at St. Louis. Greenspan’s statements are often interpreted as reflecting support monetary policies that would keep overall inflation no higher than a 2% to 3% range, according to White. Most Fed observers expect Bernanke to be more explicit in identifying the numerical target or zone.


If the Fed were to set an explicit inflation target, it would be seen as a watershed for the central bank’s conduct of monetary policy. Advocates of inflation targeting contend it would bring clarity and more accountability to Fed policy decisions, according to Charles I. Plosser, professor of economics and public policy at The William E. Simon Graduate School of Business Administration at the University of Rochester – and co-chair of the Shadow Open Market Committee, a group of economists who closely monitor Fed policy and who are strong advocates for price stability.


“People did not know what Greenspan’s policies were. He used his own judgment and skill and maybe a bit of luck. There was no guide book,” says Plosser. The problem with the notable achievements of Greenspan as an inflation fighter, he says, is that they are largely those of a single individual and are not necessarily ones that will pass on to future members of the Open Market Committee, Plosser says. By adopting inflation targeting and identifying an explicit target, Bernanke may be able to institutionalize and make transparent the inflation fighting policies that Greenspan developed through consensus with the Open Market Committee, says Plosser.



Will Bernanke be able to convince the Fed to do inflation targeting? Maybe. Maybe not. Says Jones: “It will be difficult for him to achieve a consensus on a specific rigid target.” As a result, Bernanke might focus on a 1% to 2% target for core consumer inflation and “make that the unofficial comfort zone,” Jones says. Other observers suggest it will not be easy for Bernanke to prevail. “He’ll try to persuade his colleagues on the board that an inflation target is a desirable feature,” and that it should not be just a commitment of Alan Greenspan but of the Fed, says Plosser. “A lot may happen behind the scenes to begin with. Bernanke may do some political education and marshalling of forces, Plosser says. Niskanen says there is already some support for inflation target within the Fed and the Open Market Committee, but that the support is not uniform. “This means there will not be moves precipitously in any direction for awhile,” Niskanen says.


Core Inflation


Why is it so important to have an inflation target? For one thing, without an identified target, “we really don’t know what the Fed’s goals are,” says Plosser. Secondly, “Everybody seems to reasonably presume that the Fed seems to be content with an inflation rate of 2%.” Yet, it is not clear what that means. “Does it mean they are working within a range between 1% to 3%?” The issue gets even hazier when you notice that during the last year overall inflation has been above 2% while core inflation has remained below 2%, says Plosser. Would an inflation target be aimed only at core inflation or would it be set for overall inflation? Or would there be separate targets for core and overall inflation?


Then there’s always the question of which inflation measure does one follow. The consumer price index – either with or without food and energy prices – has traditionally been the most widely followed indicator in the press and by the public. During the Greenspan era, the Fed expressed a preference for the price deflator for personal consumption expenditures (PCE0. Throughout most of 2005 the PCE deflator was above 2%. It hit 3.8% in September and 3.4% in October in the aftermath of hurricanes Katrina and Rita, when energy prices jumped.  It fell back to 2.8% in November and December. Taking out food and energy prices, the core PCE deflator remained below 2% throughout 2005 – indeed hovering in a narrow range between 1.6% and 1.7%. “The good news is that there is not much inflation despite the jump in energy prices,” says Jones.


Raise, Lower or Hold?


The markets and the pundits, for the most part, believe that the Fed’s rate tightening is over or nearly over. At the same time, however, there are others who expect the Fed to move to reduce rates before the end of the year – or conversely to continue raising rates to curb excess demand in the economy.


Any decision by the Fed is fraught with the potential for mistakes. Certainly some of the decisions at the Fed have been met with their share of criticisms. For example, Larry Kudlow, an economist and host of CNBC’s Kudlow and Company, faulted the Fed for aggressive rate hikes in the late 1990s when unemployment dropped to 3.9 percent, real economic growth was above 4 percent at a time when Greenspan spoke of the “irrational exuberance” of the stock market. In response to this strong growth, the Fed raised rates, leading to “a generalized deflation of commodity, equity and business investment, according to Kramer.”


The task for the Fed is inherently difficult because the Fed has to anticipate where inflation will be in the future and take steps today to be sure it does not increase tomorrow, while also considering the potential impact of those decision on the future of the economy. Yet, there is a delay of two year’s from today’s decision and the impact it will have on inflation – and a delay of six months for the impact on the. Thus, the Fed does not know whether or not it has made a correct decision until long after the decision is made. Because of the delayed effect, the process of setting monetary policy has often been likened to “driving by looking in the rear view mirror.”


The Fed, as it did under Greenspan, will continue to watch the data. But which data does it watch the most? Jones says the Fed, as Greenspan once told him in response to a query, tries to read capital markets, both pricing and rates, and interest-sensitive sectors of the economy, to see the impact of monetary policy and look for signals about the future direction of the economy and inflation. How does one interpret the data? There’s no simple solution or formula that can assure the Fed will get it right.  “It’s really an art, not a science, no matter how sophisticated our economic modeling may be,” says Jones.


A common worry today is that rates have been rising so long that it may be pushing the economy into a recession, especially the housing sector. Bernanke has recognized that risk in his testimony. “Given the lags in the effect of changes in monetary policy, it may be important for the Fed to pause,” says Jones. “The last thing you want us to do is to invert the yield curve, create softness on the shoulders.” Jones points out that the flat yield curve is making life hard for banks, which make money by borrowing short term and lending long term. “They have a disincentive to lend when the yield curve is inverted or flat,” he says. The flat curve will lead, he expects to credit constraints that are likely to make the economy slow down to between 2 ¾% and 3% for all of 2006.


The yield curve for bonds in the United States has been flat since late last year, as the Fed pushed up short term rates, while long-term rates remained low. Since late December there have been times when some shorter-term rates have been higher than the longer-term rates along the yield curve. In the past, an inverted yield curve has often preceded an economic downturn. However, in response to a question during his testimony before Congress, Bernanke disagreed with the notion that an inverted yield curve necessarily leads to recession.


Delayed Effect of Rate Hikes


Bill Gross, Managing Director at Pacific Investment Management Co. LLC Newport Beach, California, is concerned about the 350 basis points [Update after March 27/28th meeting CHECK TK] hike in interest rates, spaced in quarter point increases over the last two years. “We’ll see the effect of those increases for a long time,” Gross has warned. While it appears that so far there will not be a bursting of the housing bubble – and indeed some argue there was no bubble – a sharp slowdown in the housing sector could take away the tailwind that housing has provided for the economy for the last several years. Since the housing market historically has been a lagging market, it will be awhile for the true impact of a long stream of quarter rate impacts will be seen, according to Scott Simon, mortgage market analyst and managing director at PIMCO. He notes that one of the biggest surges in home prices occurred in 2005, “over a year after the Fed began raising rates.” The effect of the earlier lower rates was still propelling the market, he says. Simon compares the delayed effect of monetary policy on the housing sector to turning around a supertanker. “You have another 20 miles of cruising when you throw it into reverse,” Simon says.


A key worry going forward is whether homeowners can afford to pay their mortgages as payments are reset on Interest Only and Option ARMS – a big chunk of the market in recent years. Resets on these products vary from one to seven years, with an average of four years, Simon says, so it will take awhile for the full impact of higher interest rates to hit borrowers who took out Interest Only and Option ARMS. Already, he says, many adjustable rate mortgages tied to LIBOR and short-term Treasuries carry payments that are higher than 30-year fixed rate mortgages.


Simon, who has studied housing bubbles over the last 200 years, does not expect the housing market to crash. If one looks at the historic record, he says, one finds that “it only came apart when there was big unemployment.” Simon cites as examples of crashes the Texas and Louisiana in the oil patch in the late 1980s when there was 35% unemployment, California in the early 1990s when there was a dramatic shrinkage in the defense industry and huge layoffs, and New England in the early 1990s where unemployment was also high. While there will be not crash, PIMCO has predicted that a slowing housing sector will be a key factor in slowing the economy to 2% GDP growth by the third quarter, prompting the Fed to lower the fed funds rate before the end of the year.




Will the Fed overshoot its target in this round of rate hikes and bring about an economic slowdown? That happened in 1994 and 1995 when the Fed erred on the side of inflation fighting and there was a significant slowdown in the economy in 1995. It was not a soft landing. This time, however, the Fed may do better. Jones, for example, thinks that the Fed has already reached a fed funds rate level that is consistent with contained inflation and allowing the economy to grow in line with its potential. He sees no reason rates should be raised in anticipation of future inflation, given the fact that energy costs have not driven up core inflation. “I would agree next time the Fed makes a change in policy, it will ease – and this is more likely to occur in 2007 rather than 2006,” Jones says. This means, he contends, the Fed will hold interest rates steady for most of the rest of the year. Jones is yet another observer who expects the economy to slow to a 2% to 2 ½% by the end of the year. This projected slowdown will lead the Fed to consider whether or not it should do a rate cut on balance. “The Fed will try to get it right,” says Jones. “The Fed will achieve its soft landing.”



Most housing economists are predicting only a slight slowing of growth this year, with the growth in housing sector below 2005 gains but close to the levels of 2004, or perhaps higher. David Seiders, chief economist for the National Association of Home Builders, predicted earlier this year that housing starts will decline by 6.5%. Frank Nothaft, senior economist at Freddie Mac has forecast a 6% to 8% decline in home sales, a 6% appreciation in home prices, and a 14% to 15% decline in refinancings. David Berson, chief economist at Fannie Mae, has forecast home sales will decline 8% with only a 3% appreciation in home prices. Despite this slowing, he expects overall economic growth to be around the trend rate of 3.5%. Berson does not expect the full effect of the Fed’s rate hikes to hit the economy until 2007. If the Fed continues to tighten and long rates move down, the markets will see not just an occasional short-term rate with a few basis points above a single long-term rate, but “a true whole yield curve inverted,” says Berson.



Berrnanke’s notice that he will be watching for any unusual levels of weakness in the housing sector should reassure Fed watchers that he will be prepared to address any potential crisis that might ensure from a sharp downturn in residential real estate. Jones points out that Bernanke has emphasized in his research on the Great Depression that if a bubble breaks, the Fed should be aggressive in responding with an infusion of liquidity, as it was in 2001, when the Greenspan Fed responded to the bursting of the stock price bubble by adding liquidity, according to Jones. Bernanke agrees with Greenspan, he adds, that the Fed should not move to burst a bubble “unless it leads to excess and inflationary growth – for example, if higher stock prices and homes prices created a wealth effect that led to excessive growth.”


The Flat Yield Curve


Bernanke, like most economists, sees a connection between the huge inflow of foreign capital into the bond market and the persistent low rates for long-term bonds even as the Fed has continually raised short-term rates. (See Side Bar titled “Why Foreign Funds Flow to U.S. Bonds.”) Usually, higher short-term rates lead to higher long-term rates. Yet, during the last run-up in short-term rates the long-term rates have remained low. The fact that long term rates did not seem to respond to rate hikes, but instead fell beginning about the time the rate hikes began led Greenspan to describe the phenomenon as a “conundrum” in testimony before Congress in February 2005. By “conundrum” he apparently was saying it is difficult to pinpoint why it is occurring.


Greenspan observed in his testimony that the greater integration of financial markets around the globe has led to a larger share of the world’s pool of savings moving across borders to be invested elsewhere. At the same time, Greenspan noted, the increased capacity to produce goods and services across countries had contributed to the lower inflation expectations, but since this trend was not a new one and is a trend that moves “glacially,” it could not fully explain the low long-term rates. “For the moment, the broadly anticipated behavior of world bond markets remains a conundrum,” Greenspan said. ”Bond price movement may be a short-term aberration, but it will be some time before we are able to better judge the forces underlying recent experience,” he added.


Confidence in the Fed’s ability to contain inflation is also a factor in the low long-term rates, according Berson. “Right now the consensus view is that core inflation will remain at 2%,” he says, and the markets are reflecting that view. From Berson’s perspective, “The financial markets are correct that the Fed will not let underlying inflation get out of hand.” Since the markets are confident about the Fed’s ability to keep inflation in check, Berson does not expect long-term interest rates to rise more than a quarter point by the end of the year. With short term rates expected to remain high or maybe go higher, this means that there may be a flat yield curve for the rest of the year. Or, perhaps longer, according Ed Gramlich, former Fed Governor who is now the interim provost at the Gerald R. Ford School of Public Policy at the University of Michigan in Ann Arbor. “In some sense, a flat yield curve should be an equilibrium position,” Gramlich says. “It’s a bit of a puzzle why the yield curve slopes upward,” he adds. Theoretically, the longer term rates are pricing the potential inflation risk. However, if inflation goes away, then the difference between longer and shorter term rates should decline, Gramlich contends.


Some observers have expressed concern that foreign purchasers may reduce their purchases of U.S. Treasuries and other bonds. Duncan, for one, says he does not see the trend of strong purchases reversing itself. These nations have important reasons to be buyers and those reasons are not going away. For example, some countries are holding reserves to keep their exchange rates from falling, which, if it fell, would harm their export industries, Duncan says. In many developing countries, investors and central banks do not have domestic investments that are viable to hold. “If there were a loss of confidence in either the dollar or U.S. securities, where will the Chinese put their money? Or, the Japanese?” Duncan sees few opportunities around the globe for investors and central banks and, so, the money will continue to flow to the United States where it can achieve the highest risk-adjusted rate of return, according to Duncan.


And yet, the American economy remains dependent on decisions by foreign central banks, Niskanen says. He says the United States borrowed $800 billion to $900 billion last year. “That’s much too high. It makes the U.S. vulnerable to a decision by central banks. He noted that China now has $819 billion in dollar reserves. And that last year when South Korea’s central bank said it was not clear that it should increase purchases, it led to a dollar sell off. “We’re quite vulnerable to a decision by Asian central banks. I think it is unlike they will buy as many as in recent years,” says Niskanen.


The Fed should expect crises and be prepared to respond, according to Niskanen, who recalls that Greenspan faced a huge crisis only a few months into his first term as Fed chairman when the stock market crashed in October 1987. Greenspan responded by pouring a lot of money into the market short term to be sure there was no liquidity crisis and then “took it out slowly over a period of time,” Niskanen says. Greenspan essentially did the same thing all over gain after the 1997 Asian financial crisis, following by the 1998 Russian and 1999 Brazilian defaults and in anticipation of a potential Y2K crisis that did not materialize, he adds. While it was necessary to take away the stimulus that had been advanced into the markets, Niskanen says, in each case the withdrawal of the funds led to a mild recession, one in 1991 and the other in 2001.


For now, foreign central banks appear content to continue purchasing U.S. Treasury bonds. This inflow of funds will, then, keep the yield curve flat for awhile – “at least until early 2007,” according to Duncan. “The flatness of the yield curve is not a sign of coming economic weakness, Duncan says, dismissing worries about an inverted yield curve. At times since late 2005, some short-term interest rates have been higher than long-term rates, producing an inverted yield curve, at times as tiny as 2 basis points, and lasting only a day or so. “There is no solid evidence that an inverted yield curves leads to recession,” he says. Duncan believes the next move at the Fed will be to cut rates – although it may not come until mid to late 2007, he predicts. He thinks the Fed will study rates for awhile after they stop raising them to look to see if there is any evidence of pricing power; that is, the ability of companies to pass on higher costs from energy or labor to buyers.

And what about mortgage rates? While Duncan expects the flow of money into the United States to keep long-term rates low, the spread between the 10-year Treasury and mortgage rates is likely to widen. The spread has already widened by 20 basis points, Duncan says, since the housing market peaked last summer. Duncan expects the spread to widen another 20 basis points, pushing it from 155 to 175 basis points over the 10-year Treasury rate. This should put the mortgage rate at 6.5% by year’s end, Duncan says. Since many adjustable rates are already higher than the long-term fixed rate, it is likely to lead to a decline in the market share for ARMS, which Duncan forecasts will shrink from 35% last year to 31% this year and 25% in 2007.


Demand and Inflation


Despite worries about a weakening housing sector or slowing economy, the Fed will consider raising rates if it sees signs of inflation affecting core prices. “When inflation is higher than your target numbers, you tighten no matter what else is happening. The Fed will have to act,” says Niskanen, who contends that growth in demand in the economy may signal potential inflation. Demand is growing at 7% to 8%, which is “too high to sustain an inflation rate below 2%,” Niskanen says. That’s significantly above the long-term average of 5.5% during the 18 ½ years of the Greenspan era. Niskanen contends that demand will have to come down to 5% which, in turn, will require the Fed to keep tightening until it does. Niskanen identifies the demand indicator as the quantity index for Real Final Sales to Domestic Purchasers published quarterly in the National Income and Product Accounts by the Bureau of Economic Affairs. The demand quantity index stood at 116.831 in the last quarter of 2005 (the year 2000 = 100 on the index). Two years earlier in the fourth quarter of 2003 real final sales to domestic purchasers stood at 108.448.


Niskanen suggests that the effect of strong growth in the economy is showing up in big increases that have been reported in the current account deficit and home prices. In 2005, the current account deficit for the U.S. reached a record $725.8 billion, significantly higher than the $617.6 billion deficit for 2004. Home prices appreciated 12 percent in 2005, far above the historic norm of 3 to 4 percent, but down 12 appreciation rate of [CHECK TK Number for 2004] and [2003].


Labor Costs and Productivity



The Fed’s focus on labor costs is also expected to intensify in view of the decline of unemployment to 4.7% early this year and the growing number of new jobs created monthly. “Clearly they’re going to be slightly increased inflationary pressure. All you have to do is look at the jobless claims, says Bob Hormats, Vice Chairman of Goldman Sachs. “This will mean somewhat higher wage pressure, a modest decline in productivity and a tighter workforce,” he adds. In this climate the Fed will look to see if potentially higher labor costs are passed on by businesses to their customers. Gains in wages need not be inflationary if productivity gains are continuing at the high levels of the last 11 years. However, productivity gains slowed in the last half of 2005.


Bernanke, in a lecture given January 19, 2005, at the Little Rock Business Forum at the University of Arkansas, examined the causes behind the extraordinary improvements in productivity in the United States that began after 1995, and what to expect for productivity gains in the future. His views can shed some light on how the Fed might respond to changes in productivity levels.


U.S. productivity which had been at 1.5% per year from the early 1970s until 1995, jumped to 2.5% in the years between 1996 and 2001. It rose to even higher to 4% in the years between 2001 and mid-2005. In his lecture Bernanke attributed a big chunk of America’s advantage in productivity to its better deployment of intangible capital, which includes supplementing purchases of new equipment with investment in research and development to better use the equipment, worker training, and organizational redesign. Bernanke also described in his lecture the productivity cycle of businesses. In the early stages of recession companies are reluctant to hire new workers and often make current employees work harder. This pushes up productivity. As the economic expansion matures and hiring picks up, productivity growth slows down back toward a normal level, Bernanke said. The U.S. economy “has likely entered this latter stage, as productivity growth appears to be falling from its recent high levels to a rate that is likely below longer-term trend,” he stated. Bernanke cited the work of several economists (Martin Bailey, Robert J. Gordon, Dale Jorgenson, Mun Ho, and Kevin Stiroh) who make the case that productivity gains should soon return to the 2.5% trend rate. While productivity declined in the last two quarters of 2005, some of that loss should be attributed to the effect of the hurricanes that devastated parts of Louisiana, Mississippi and Texas. In his February testimony Bernanke indicated he expected productivity to recover from the low levels in the fourth quarter. To the extent productivity recovers, it would allow for gains in wages that are not inflationary.


So far there are no signs of any inflationary pressures on wages. “Everything I’ve seen is that wages are soft,” says to Gramlich. “People are talking about wage income not keeping pace.” Yet, labor costs bear watching to look for signs of inflation, according to Duncan. He expects productivity levels to return to an average annual gain of 3% (average the gains from 1995 to 2005). Yet, with productivity slowing last year, there is some evidence of price pressures from rising unit labor costs, which are wage rates adjusted for productivity. “The productivity assumption is important,” says Duncan. If productivity declines, the cost pressure can pass through into higher prices, and prompt the Fed to tighten. If productivity returns to the 3% per year level, rising wages may not lead to higher unit labor costs.


So, like players in a poker game with stakes as big as the entire U.S. economy, the members of the Fed’s Open Market Committee will deliberate on monetary policy against a backdrop of rising uncertainty about the direction of monetary policy. Even though Bernanke is likely to provide more transparency about the Fed’s decisions, monetary policy has reached a particularly murky point. Expect the Fed to hold the cards close to the vest. It may get lucky, at least in the early days. “If inflation is low and stable, the Fed won’t initially be required to do much,” says Jones.




Side Bar:

Why Foreign Funds Flow to U.S. Bonds


“Why is the United States, with the world’s largest economy, borrowing heavily on international capital markets – rather than lending, as would seem more natural?”


That was the central question addressed in a lecture by Ben S. Bernanke to the Virginia Association of Economics on March 20, 2005, when he was a Fed governor. In his presentation – “The Global Saving Glut and the U.S. Current Account Deficit” – he offered an answer. A global saving glut is the driver of both the rising U.S. current account deficit and the relatively low level of long-term interest rates in the United States and around much of the globe. This view contrasts with the more conventional view that the low U.S. saving rate is to blame for the current account shortfall, making the current account deficit “made in the U.S.A.,”


Why is there a global savings glut? Bernanke identified the aging of many developed nations as a key factor in the increase in global savings. As fertility rates decline, there are fewer people in the younger age cohorts than in the older ones and, thus, fewer investment opportunities where savings can be put to use. (The U.S. is aging much more slowly and has a large flow of immigrants so that the aging impact is muted here.) The aging phenomenon in other countries, however, is not enough to explain the significant rise in the U.S. current account deficit, Bernanke said. Nor can it explain the recent sharp increases in the U.S. current account balance. Instead, Bernanke said, one has to look to the developing countries in Asia and Latin America to find the source of the huge build up in global savings. These developing nations have changed roles. They used to be major borrowers. Now they are big time lenders.


To make his point, Bernanke cited data for the period 1996 and 2003, when the U.S. current account deficit widened by $410 billion. Where did the funds come from? A small part – $22 billion – came from aging industrial countries, whose collective current accounts declined by $388 billion, Bernanke said. By far the biggest source of funds is the developing countries, which as a group went from a deficit of $88 billion in 1996 to a surplus of $205 billion, a net change of $293 billion. The developing nations added another $60 billion in lending in 2004 (and more in 2005).


What caused the change in the direction of money flows to and from the developing world? Basically, the investments flowing into developing countries were squandered or poorly invested in one way or another and, as a result, led to a series of painful financial crises, including those in Mexico in 1994, in a number of East Asian countries in 1997-98, in Russian in 1998, in Brazil in 1999, and in Argentina in 2002. “The effects of these crises include rapid capital outflows, currency depreciation, sharp declines in domestic asset prices, weakened banking systems, and recession,” Bernanke said.


As a result of the international crises of 1996 to 2002, developing nations either chose or were forced into new strategies for managing international capital flows, Bernanke said. For example, South Korea and Thailand built up large foreign exchange reserves. China, which avoided its own crisis, was worried enough about a future crisis that it also began to build up reserves. The developing nations invested in export industries and depressed domestic investment as a way to build up their capital surpluses. Developing country governments issued debt to their citizens, mobilized domestic saving, and then used the proceeds to buy U.S. Treasury securities and other assets. “Effectively, governments have acted as financial intermediaries, challenging domestic saving away from local uses and into international capital markets,” Bernanke said. Governments have also issued government debt to pay down external debt. The sharp rise in oil prices has also helped shift other non-industrial countries into a surplus, including countries in the Middle East, as well as Russia, Nigeria, and Venezuela.


As Bernanke noted, the developing nations could not increase their current account deficits unless the developed nations reduced theirs. While aging industrial nations would be expected to increase savings because of a lower requirement for investment, this has not happened, he said. Instead, the shift in current account positions was facilitated by higher asset prices in the developed countries and exchange rate adjustments. From 1996 to 2000, the flow of foreign funds drove up equity prices in the United States and other countries, Bernanke said. The increasing wealth of America’s growing investor class helped fuel more spending that further widened the trade deficit, he added. This, in turn, reduced Americans’ propensity to save. “Thus,” Bernanke said, “the rapid increase in the U.S. current account deficit between 1996 and 2000 was fueled to a significant extent both by increased global saving and the greater interest on the part of foreigners in investing in the United States.”


After the stock market began to decline in 2000, the holders of the world’s savings turned increasingly to fixed income securities. This, in turn, helped drove down the real rate of interest, Bernanke says. “From a narrow U.S. perspective, these long-term rates are puzzling, from a global perspective, they may be less so,” Bernanke said. Low bond rates meant low mortgage rates, and the low mortgage rates helped fuel a boom in residential real estate in the years after 2000.


The appreciation in home values has pushed the wealth-to-income ratio of U.S. households to 5.4, approaching the peak value of 6.2 of 1999 and well above the long run average of 4.8 between 1960 and 2003. Bernanke said that the gains in home equity also contributed to a low saving rate in the U.S. as homeowners tapped cash-out refinancings to increase spending and investment, while rising government deficits added to the overall decline in U.S. saving rates. National saving was further reduced as the U.S. business investment cycle began a recovery, Bernanke explained.


The global savings glut has affected other developed countries, too. Bernanke pointed out that the current accounts of France, Italy, Spain, Australia, and the United Kingdom have moved toward current account deficit since 1996. These same countries have also tended to experience gains in home values and household wealth. Wealth-to-income ratios rose 14% in France, 12% in Italy, and 27% in the United Kingdom while they remained flat in Germany and Japan, Bernanke noted.


Should one worry about huge inflow of global savings into the United States? Bernanke advised that it is “undesirable as a long-run proposition” to have global savings flow to the developed nations rather than the developing and emerging economies. Economic logic argues that the aging developed countries in the long run should have current account surpluses and should be lending to the developing world, he said. “If financial capital were to flow in this ‘natural’ direction, savers in the industrial countries would potentially earn higher returns and enjoy increased diversification, and borrowers in the developing world would have the funds to make the capital investments needed to promote growth and higher living standards,” Bernanke said. For this to occur, developing nations will have to improve conditions for investment at home. As for the United States, foreign capital inflows that increase residential construction and increase consumption also increase the future economy burden of repaying foreign debt, Bernanke said. It is, he said, preferable for the investments to go into export sectors so the United States can earn the funds to repay foreign credits in the future.


The capital flows into the United States are likely to continue for the medium and perhaps long term, according to Bernanke, allowing for a gradual adjustment back to a more sustainable balance. “I see no reason why the whole process should not proceed smoothly,” he stated. “However, the risk of a disorderly adjustment in financial markets always exists, and the appropriately conservative approach for policymakers is to be on guard for any such developments.” How can this imbalance be addressed? While it is a good idea to reduce the federal budget, this would not substantially reduce the current account deficit, Bernanke said. He generally supported the creation of additional tax-favored saving vehicles, which he felt would help, as would any overall increase in the saving rate. However, since the chief causes of the capital inflows lies outside the United States, inward-looking policies in America will not help bring about the required adjustment. He contends, rather, that “a more direct approach is to help and encourage developing countries to re-enter international capital markets in their more natural role as borrowers, rather than lenders.” If developing countries strengthened property rights, reduced corruption and removed trade barriers, it would also help. So would steps to improve banking regulation and supervision with more transparency to help prevent financial crises, Bernanke said.


-- Robert Stowe England




Robert Stowe England is a freelance writer based in Milton, Delaware, and author of Black Box Casino: How Wall Street’s Risky Shadow Banking Crashed Global Finance, published by Praeger and available at Amazon.com. He can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..


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Robert Stowe England is an author and financial journalist who has specialized in writing about financial institutions, financial markets, retirement income issues, and the financial impact of population aging.

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