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Generational Dynamics Web Log for 10-Oct-04
The Fed congratulates itself - again - on its jawboning policy

Web Log - October, 2004

The Fed congratulates itself - again - on its jawboning policy

The Fed appears to be indicating a slowdown on interest rate increases in a lengthy self-congratulatory analysis of the Fed's jawboning policy.

Federal Reserve Governor Ben S. Bernanke emphasized that the Fed has been following a gradualist approach in raising interest rates.

His emphasis has led some analysts to read between the lines and conclude that the Fed plans to slow down its program to increase interest rates.

This speculation increased on Friday, after the September jobs report was much poorer than had been expected.

However, today we want to focus on the main thrust of Bernanke's luncheon speech on Thursday to the Japan Society.

Bernanke talked at length about the Fed's jawboning policy -- providing guidance on the Fed's view of the economy, so that investors will be able to make longer range plans, based on a reasonable expectation of what the Fed will do in the future.

So when the Fed said earlier this year that it would proceed with interest rate increases "at a pace that is likely to be measured," investors could reasonably conclude that interest rate increases will be gradual.

Now, I have no objection to more information from the Fed. I think it's great. What bothers me is what bothered me last month when I criticized Bernanke because he seemed to be saying that verbal statements from the Fed can affect stock prices in the long run.

In Thursday's speech, Bernanke didn't talk about stock prices, but he did talk about falling interest rates on 10 year notes that are occurring at the same time that interest rates are rising on short term notes.

According to Bernanke, the reason that interest rates are falling on ten year notes is as follows:

The Fed repeatedly made verbal statements that short-term interest rates would be increased at "a measured pace," and particularly would keep inflation under control.

Therefore, the market decided that the Fed would keep inflation at moderate levels in the long run.

Therefore, the market concluded that long term interest rates should fall.

Bernanke has a good point here when he relates inflation to long-term interest rates, and it's a point I should have discussed when I wrote last month that yield curves are flattening, indicating a problem.

It's true that interest rates in general are related to inflation, and that if inflation is under control, then interest rates are likely to be lower.

But the problem I have with all this is that it completely ignores fundamentals. When I last criticized Bernanke, I pointed this same thing out. Bernanke apparently believes that the Fed can use verbal statements, even misleading verbal statements, to affect the economy -- stock prices, interest rates (bond prices), and so forth -- in the long run!

If you want a simple demonstration that verbal statements by the Fed don't work, take a look at Alan Greenspan's 1996 statement complaining that the high stock prices were a sign of "irrational exuberance." This statement got a great deal of media play, but it didn't stop naīve investors from bidding up the prices stock to astronomically high levels, which only fell after the Nasdaq crash in 2000.

What Bernanke doesn't even discuss is the kinds of fundamentals that I described in my piece on flattening yield curves: that public debt is at astronomically high levels, higher than even in the 1930s, that stock valuations (as measured by price/earnings ratios) are at historic highs, worse than even in the 1930s, and that the common measures of inflation (the Producer Price Index (PPI) and Consumer Price Index (CPI)) are showing that the economy is in a long-term deflationary period, not an inflationary period.

In Bernanke's strange world, fundamentals like these are completely irrelevant. Nothing matters except what the Fed says and does.

When Bernanke gives historical examples (in this speech, and in a speech that he gave on Friday on another subject,) his historical examples never go back more than a few decades.

Once again, we see why Generational Dynamics can provide the accurate forecasts that it does. Generational Dynamics says that today we're in another period like the 1930s, but even professionals like Bernanke can't go to the trouble to make historical comparisons to the 1930s, because they have no personal memory of anything that happened before they were born, and tend to discount it all.

I'm glad that the Fed is providing more information, but I object to the vanity, conceit and self-deception that Bernanke and the other Fed Governors exhibit when they claim that verbal messages can affect long-term interest rates. More information from the Fed means less volatility in short-term rates, resulting in less volatility in derivative values, including stock prices and the value of the dollar, in the short term.

But the Fed's verbal statements provide at most six months of guidance beyond what the market would know if the Fed provided no verbal guidance whatsoever. In the end, it's necessary to look at the fundamentals, and that's what the Fed and most other analysts are avoiding.

Finally, here's an aside: On Friday, a Wall Street Journal editorial criticizes Bernanke's speech, and the Fed in general, for not raising interest rates more quickly. The editorial blames the Fed for high oil prices and says that "the Fed may lose its focus on its core mission, which is supposed to be maintaining price stability."

Apparently the people who write WSJ's editorials don't bother to read the paper's own news pages. Oil prices are at a historic high, but that's because of China's increasing demand for oil, not because of anything the Fed is doing. And anyway, we're in a deflationary, not an inflationary, period, as the news about the PPI and CPI for the last few months has shown. (10-Oct-04) Permanent Link
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Generational Dynamics Web Log for 10-Oct-04 The Fed congratulates itself - again - on its jawboning policy

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Generational Dynamics Web Log for 10-Oct-04
The Fed congratulates itself - again - on its jawboning policy