Bernanke's Continuing Dilemma Comstock Partners, Inc. Thursday, May 4, 2006
Although Ben Bernanke’s comment to Maria Bartiromo that Wall Street misinterpreted his congressional testimony was delivered in an unorthodox and unwise manner, he was, of course, entirely correct as is evident to anyone who listened to or read his statement. In his testimony, Bernanke clearly stated that the FOMC could pause at some point, but that this would not preclude a resumption of the rate hikes based on incoming data. That the Street chose to concentrate only on the pause and virtually ignore the follow-on must have alarmed the new Chairman, who is still trying to live down the unfortunate statement he made a few years ago about the possibility of throwing money out of helicopters if necessary to prevent damaging deflation.
The present problem, though, is that the Fed is faced with potential inflation on one side and damaging deflation on the other with little solid ground in between. The dilemma has been a long time in the making and threatens to come to a head on the new Chairman’s watch. Alan Greenspan was, in effect, a short-term crisis manager dealing with the 1987 crash, the savings and loan crisis, the Mexican crisis, the Asian currency crisis, the LTCM collapse, the millennium computer problem and the post-2000 market decline and recession. Although he managed to get through each crisis with minimal damage, the result is a record trade deficit, a huge budget deficit, record household debt, a negative consumer savings rate and a massive housing boom now threatening to unwind.
Since gains in employment, wages and salaries have been anemic since the economic trough in late 2001, consumer spending has been kept afloat by the drastic decline in the savings rate combined with the massive sums raised from mortgage equity withdrawals. With economic growth facing strong headwinds from the softening housing picture, any further tightening by the Fed could lead to severe consumer debt problems and pose a threat to the banking system that results in a deflationary unwinding of debt. This is what obviously concerned Bernanke three years ago and what is probably still on his mind today.
The obvious solution then would be to stop raising rates and even start lowering them to prevent such a deflationary catastrophe. This, however, leads us to the other side of the problem—potential inflation. Gold is at its highest level in 25 years and industrial commodity prices are soaring. Energy prices recently made historic highs. The idea that the Fed may stop hiking rates while other nations are raising theirs was enough to send the dollar plunging over the last 10 days. While rising energy and other commodity process have not yet spilled over into the general economy, they seem pretty close to doing so. Today’s Wall Street Journal carried an article showing that a wide array of companies in different industries are tacking on fuel fees. These include, among others, airlines, delivery companies, cruise lines, electric utilities, garbage collectors, landscapers and pizza chains. Other companies that have not passed along escalating costs to consumers say they may have to do so soon.
In our view the Fed is in a box where anything they do may turn out to be wrong with deflation waiting on one side and inflation on the other. After many years of dodging the bullet through short-term crisis management the Fed appears to running out of options. The stock market may already be sensing that this is indeed the case. While the media trumpets multi-year highs in the averages, the S&P 500 has struggled to a paltry 1.3% gain since January 11. Daily new yearly highs on the NYSE were 480 in January 2004, 320 in November 2004, 290 in July 2005, 260 in February 2006, and 200 now. The number of NYSE stocks exceeding their 200-day average has declined from 91% in early 2004 to 65% now. With the S&P 500 still substantially overvalued, we believe that the risks far exceed the potential rewards at this time.
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