Can Bernanke Pull it Off?

Can the Federal Reserve smoothly dismount out of its unorthodox, experimental policy moves to bring the economy back from the brink, moves that have doubled its balance sheet to $2 tn in a year's time and that have left it vulnerable to potentially $6.8 tn in gross exposures?

Federal Reserve chairman Ben Bernanke, up for reappointment in January 2010, testified at day two of hearings at a Senate Banking hearing on Capitol Hill about the Fed's monetary policy and the quantum leap in the Fed's balance sheet caused by the science project it's built out of its quantitative easing programs.

Bernanke also testified as to whether the Federal Reserve can acquit itself of new potential duties as the systemic risk regulator, as the White House wants, at a time when some in Congress believe the Fed and the Treasury Dept. themselves pose systemic risk.

And the broader, open-ended question lawmakers wrestled with is whether the world's most powerful central bank can forestall any bout of rampant inflation from its massive, unconventional interventions, as many economists fear.  

While the economy still feels to many as if it's bicycling through quicksand, the government bailouts are not cinematically picture perfect, and even the most dovish Fed officials are troubled by signs that the market is worried about deficits and inflation.

Janet Yellen, San Francisco Fed president, recently described market unease over the Fed's moves as "disconcerting."

Bernanke made it clear that the Fed funds rate will remain low for some time, until well into 2010, which some Fed officials are uneasy about--including Dallas Federal Reserve president Richard Fisher, who has already warned that easy money is like "tequila, tasty but dangerous."

"Do you have the will to take away the punchbowl?" Sen. Jim Bunning (R-KY) asked Bernanke at the hearing.

The Fed chair replied yes, the central bank will tighten when necessary. "We will absolutely do it so long as we will not be forced to do it by Congress," Bernanke testified, adding, by legislative "mandate, we will enforce full employment and price stability."

And at the hearings, Bernanke met with some Congressional resistance over his unwillingness to discuss when he plans to stop his quantitative easing.

However, other economists believe the Bank of Japan derailed the effectiveness of its policies when it mistakenly and publicly discussed too often its exit strategy plans while at the same time enacting fiscal stimulus programs to restart its economy during the '90s, potentially lengthening its zombie decade.

What the Fed Has Enacted

Estimates show that the Fed's purchases of long-term government and mortgage-related bonds have in turn created massive new reserves for banks.

Those reserves now stand at $782 bn vs $10 bn or so before the market meltdown.

However, the Fed has purchased only about half the up to $1.75 tn in Treasury long-term debt, mortgage-backed securities and debt issued by Fannie Mae and Freddie Mac that it said it may buy, estimates show.

Through another Fed program, its commercial paper facility, the central bank became one of the biggest holders of commercial paper--$350 bn at the peak of the program, or a fifth of the market, estimates show. Companies get their short-term funding needs for things like payroll satisfied by borrowing in the commercial paper market.

That market froze when Lehman Bros. collapsed last fall, and the Fed stepped in. However, the Fed's commercial-paper holdings are down to $111 bn and fell by $1.84 bn in the week ended Wednesday, estimates show.

And overseas central banks borrowing of dollars from the Fed is running at less than a fifth of the $583 bn peak, estimates show.

Where Did All the Money Go?

One question Bernanke didn't address is this: Where did all the money go?

The banks say they are lending money, and a review of the majors' balance sheets, including Bank of America, JPMorgan Chase, Citigroup and Wells Fargo shows this to be true. All received TARP funds.

However, Neil M. Barofsky, the special inspector general for the Treasury's Troubled Asset Relief Program [TARP], said that 110 of the 360 banks to receive TARP assistance from the Treasury used it for investment purposes. 

Fifty-two of them used it to pay creditors, and 15 used it to buy other banks. About 80% of the TARP recipients said they had used just some of the money to make loans. 

Given that just less than a third of the banks used TARP money for investments, a separate question to ask is this: is the Federal Reserve driving momentum in the market, with the Dow now veering toward 9000?

As noted, the Fed has been buying US Treasuries and mortgage bonds to jack up the monetary base. But some of that money may be pouring into the capital markets. Stock and bond funds saw net inflows of close to $150 bn since January, estimates show.  

Fight Over Inflation Causes

Bernanke has ignored a number of Congressmen who believe inflation is a result of the Fed going full throttle on the printing presses. Inflation, they say, results from an overgrown money supply, that is, too much money chasing too few goods.

The Federal Reserve has instead typically focused on unemployment and the output gap, the difference between actual and potential economic growth, as being the root causes of inflation.

Other economists agree with Bernanke, that inflation is an issue of demand versus supply. When demand outstrips supply, meaning, since unemployment is now high and the economy's factory output supply is low, then inflation won't be a problem for now because companies won't have to pay more in wages or price their goods higher.

Other economists say this stance puts the central bank behind the curve as both unemployment and factory output are lagging indicators.

The issue is, bank reserves are at massive levels, $782 bn. Banks could turn these reserves into new loans that could propel new spending that could cause prices to go up.

Others say that inflation in this scenario is unlikely, given that the credit markets are still frozen over.

Either way, to many economists the central bank has ignored economists who believe its actions have cheapened the value of the dollar, as the Fed has instead focused on an inflation measure that doesn't include oil or food prices as warning signs of rising inflation.

Audit the Fed

Back in the '70s, when inflation was at historically nosebleed levels, Congress first wanted the Government Accountability Office (GAO) to audit the Fed.

The chairman of the central bank at the time, Arthur Burns, under heavy fire for not stopping inflation, had agreed to limited audits of the central bank.

Burns later reportedly said that this fight with Congress hurt his attempts at curtailing inflation. The effort of "warding off legislation that could destroy any hope of ending inflation" meant making "political judgments" that may have weakened attempts to embark on anti-inflationary measures, Burns reportedly said.

Today, Texas congressman's Ron Paul's bill to audit the Fed has gained widening Congressional support for a variety of reasons, chiefly, if taxpayer money is being abused, particularly in the case of the government making Wall Street firms like Goldman Sachs 100% whole in its trades with AIG.

Sen. Bunning, picking up on that theme on day two of the Fed hearings, asked Bernanke whether the Fed has forfeited its independence by effectively "acting as an arm of the Treasury and engaging in fiscal policy," meaning, the Fed's proposed purchases of $300 bn in Treasury bonds in a bid to keep consumer loan rates low (loan rates are typically tied to the 10-year Treasury note).

With the fed funds rate at effectively zero, the only other levers the Fed has are its quantitative easing programs, including bond buying, which so far have had a mixed result on keeping rates low.

Bond yields have been threatening to rise, raising fears the bond vigilantes will begin demanding an inflation premium in the prices of their bonds, causing rates to rise and in turn undoing the Fed's efforts to keep rates low.

Goldman Sachs estimates the government is now issuing more than $3 tn in bonds to take care of its spending needs, with more forthcoming. The government projects the deficit will amount to more than $1.8 tn in the 12 months ending September, 13% of US GDP.

"Would you rather have an audit of the Fed or give up your monetary-policy making responsibility?" Bunning asked.

Bernanke replied that he would be happy to work with Congress showing how the Fed uses taxpayer money, but that he would resist "Congressional intervention in monetary policymaking."

Historically, elected officials, in a bid to remain in power, typically want the central bank to go easy on raising interest rates so long as unemployment remains high, as voters grow uneasy over job losses.

Bunning replied: "We would carve that out [of the bill] and make sure that wouldn't be there...your job is monetary policy."

"My job is also financial stability," Bernanke rebutted, adding: "The Humphrey Hawkins bill says the Fed's mandate is full employment and price stability," referring to Congressional legislation passed in the late '70s. Bernanke then said Congressional intervention in monetary policy might create instability in the system.

"The Fed's monetary policy over the last decade has been flawed," Bunning replied, creating "bigger recessions."

Bunning also added that instead, new consumer loan protection mandates and banking regulation should go to the FDIC, and the Fed should only focus on a stable economy.

The bottom line here: An annual GAO audit would remove the control and autonomy of the Fed; whether the Fed can keep both depends on whether it's abusing taxpayer money and whether it can pull the trigger and raise rates when it needs to, false dawns in the economy or no.  

What's Your Exit Strategy, Congress?

Bernanke laid out his exit plans in an editorial in the Wall Street Journal this week.

The Fed chair also pointedly testified that the Congress needs its own exit strategy out of its massive deficit spending.

A deficit curtailment plan, (which many political observers believe is about as likely to be seen in Congress as a sighting of Elvis riding by on a magic pony), could yield lower long term rates and a healthier level of business confidence, Bernanke said. Without it, "we risk having neither financial stability nor durable economic growth," Bernanke cautioned.

Fed Wants Consumer Protection Duties

Bernanke said consumer protection ought to be added to the Federal Reserve Act along with low inflation and full employment.

This, despite answering as follows a question from Sen. Christopher Dodd, the Connecticut Democrat who chairs the Senate Banking Committee: "We were not quick enough, we were not aggressive enough to address consumer issues earlier in this decade."

Why the Fed Can't Be a Systemic Risk Regulator  

As for the plan to make the Fed the system's ubercop to wind down potentially lethal, too big to fail companies, the evidence is poor that the Fed could satisfactorily do that job.

Bernanke testified to Congress in the summer of 2007, right before the credit crisis blew up economies around the world, that the subprime crisis was  "contained" and would not go viral, despite the fact that subprime loan problems had started to pick up speed in the first half of that year.

Despite his role as the bank's chief regulator, Bernanke also was silent as the subprime bubble inflated to dangerous proportions, notably during 2006 when most of these toxic loans, many given to unqualified borrowers with no money down, were made on his watch.

And keeping rates historically low for too long created the most lethal, systemically dangerous bubble of all.

Former Federal Reserve chairman Alan Greenspan admitted recently in an editorial in the Financial Times that he was concerned a bubble was forming in the mid '90s.

"I feared 'irrational exuberance' in 1996, but the dotcom bubble proceeded to inflate for another four years," Greenspan wrote. "Similarly I opined in a Federal Open Market Committee meeting in 2002 that 'it's hard to escape the conclusion that..our extraordinary housing boom....financed by very large increases in mortgage debt, cannot continue indefinitely into the future."

The housing bubble did continue to inflate well into 2007, after peaking in the summer of 2006.

If Greenspan believed a bubble was forming in housing in 2002, then why did he choose to keep interest rates so low at 1% well into 2004?

What to Expect From the Fed

The Fed is likely to first wind down its emergency quantitative easing programs before hiking rates, a wind-down it expects will begin this September.

It next will likely attempt to mop up excess reserves, by refinancing some of its long-term assets through reverse repurchases in the banking system.

And the central bank will likely lean heavily on its ability to pay interest on massive bank reserve deposits in order to keep rates in check--whether all of this stops incipient inflation, take a wait and see.