Bernanke Inheriting a Mess
by Comstock Partners, Inc.
Thursday, October 27, 2005
It is indeed ironic that Ben Bernanke, upon his appointment as the next Fed chief, found it necessary to promise a continuation of the Greenspan policies that are likely to cause him a great deal of grief during his coming tenure. While Wall Street is narrowly focusing on Bernake’s qualifications for the job and whether he is an inflation hawk or dove, the important point is that the new Chairman will be inheriting a mess that is probably beyond the capacity of any Fed chairman to solve without a damaging recession and financial crisis.
Yes, Bernanke has an excellent resume, and, yes, the Greenspan era was marked by low inflation, decent economic growth and only two mild recessions. This economic record, however, was achieved by the creation of a record stock market bubble that ultimately burst, followed by a huge housing bubble that mitigated the damage, but led to a fragile, unbalanced economic recovery fueled by cash raised from soaring home prices. The result is record household debt, negative consumer savings rates, a huge trade deficit and a dangerous federal budget deficit. All of this is being exacerbated by record energy prices that were a factor long before anyone ever heard of Katrina or Rita.
Judging by Fed actions, statements and speeches the FOMC’s main current concern is to prevent the huge rise in energy prices from creeping into the core inflation rate, although we also sense that they have been extremely concerned about the housing bubble as well. This is evident in their moves to clamp down on the more speculative aspects of mortgage lending and in the emphasis given to housing prices in Greenspan’s speeches and testimony in recent months. Given these concerns, it seems that the Fed is signaling that they will continue to raise interest rates at the so-called “measured pace” for at least the next two meetings. If so, they will have raised the fed funds rate 13 times to 4.25%, a pace that is highly likely to result in recession and a decline in home prices.
On the other hand, if the FOMC stops raising rates now, as a number of observers suggest, they may send the wrong signals to the market, and the rising energy prices could spill over into the rest of the economy. This, too, would be highly damaging to both the economy and stock market.
Since the late 1990s the Fed has continually faced the dilemma of moving interest rates either too much or too little and, until now, has succeeded in avoiding great damage to the macro economy, although the stock market obviously suffered a major blow from which it still hasn’t recovered. At this point, however, they seem to have painted themselves into a corner, and have no place to go. That Greenspan, himself, seems to recognize this is obvious from his August speech at Jackson Hole where he said, “Thus this vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of debt that supported higher asset prices. THIS IS THE REASON THAT HISTORY HAS NOT DEALT KINDLY WITH THE AFTERMATH OF PROTRACTED PERIODS OF LOW RISK PREMIUMS.” (Caps are ours).
It seems that after 18 years of cheerleading, the Chairman, in his last months in office, is now acknowledging the potential negative consequences of his policies. He leaves, however, with the knowledge that cleaning up the mess will fall to his hapless successor, and not to him. Whether Bernanke, despite his acknowledged brilliance, knows what’s awaiting him is not known, but he will find out soon enough. In our view, this is not a time to be heavily exposed to stocks.
© 2005 Comstock Partners, Inc.
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