When Ben Bernanke took over as Chairman of the Federal Reserve in February 2006, current policy was operating under a tightening bias and the Fed Funds (or FF) rate was 4.50%. The housing market was topping and the Fed was clearly aware activity was slowing.
From the minutes
of Alan Greenspan’s last meeting in January 2006:
Activity in the housing market appeared to continue at high levels, although there were some indications of slowing... Moreover, the stock of homes for sale increased to the upper end of ranges seen in recent years.
During the real estate boom, the supply of homes on the market kept a steady rate of three to four months. But in 2005, the month’s supply began an ominous uptick. By early 2006, which is when Chairman Greenspan would leave the Fed, the housing supply was at six months.
At Bernanke’s first meeting in March, he maintained Greenspan’s tightening bias and raised the funds rate to 4.75%. Bernanke was fighting a very dovish perception from the market due to his famous “helicopter” speech in 2002. It became clear he was eager to counter his critics and demonstrate his inflation fighting credentials. In the face of noticeable deterioration in housing, Bernanke would raise interest rates at the subsequent two meetings until he got to 5.25% in June 2006 while continuing to cite inflation as the primary risk.
From the June 2006 minutes
Sales of both new and existing single-family homes in April and May were significantly below their peaks of the summer of 2005, though new home sales continued to regain some ground after having fallen in February.
The supply of homes on the market continued to rise throughout the year; as such, housing price appreciation continued to decelerate. Bernanke ceased tightening in August and removed the tightening bias, but was still adamant inflation was the primary risk.
As the US economy entered 2007, the supply of homes on the market continued to swell to seven months, and home price appreciation was rapidly decelerating dropping from 15% YOY (year-over-year) growth at the beginning of 2006 to 0% growth in early 2007. Many thought the real estate bubble was crashing at that time. Nevertheless, in January 2007, the Fed remained tight and kept the FF rate at 5.25% though noted growth and inflation were likely to moderate.
Despite the continued deterioration in housing, the bond markets would start to see some unusual price action in June as the yield on the 10YR shot up 50bps from the levels in May, reaching new highs. In the minutes
from the June 28 FOMC meeting, the Fed characterized the move as a positive “appraisal” of economic prospects:
Over the intermeeting period, however, investors seemed to reappraise their beliefs that the economic expansion would slow and that monetary policy easing would be forthcoming. This reappraisal seemed to be based in part on the release of some economic data in the United States and abroad that were more favorable than expected.
Earlier that same month, it became apparent that the now-infamous Bear Stearns High-Grade Structured Credit hedge funds were under severe pressure. The Bear Stearns funds collapsed and filed for bankruptcy on July 31. In hindsight, the spike in bond yields was the result of highly leveraged hedge funds selling liquid Treasuries to meet margin calls in illiquid mortgages, not a reappraisal. In what was a display of tight policy confirmation bias, the Fed completely misinterpreted the price action and the fact that the first domino had fallen.
A week later at the August 7 FOMC
meeting -- despite the Fed’s recognition of market volatility -- the assessment of the economy remained strong and the Fed maintained the same bias from January, keeping the FF rate at 5.25% (emphasis my own):
Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy.
The Fed was fully aware of the volatile market conditions and the housing “correction,” but remained tight. The mortgage market was melting, but Bernanke would not waver, stubbornly fighting his inflationary reputation and seemingly oblivious to the contagion risk in the interconnected credit markets.
As later reported by Bloomberg
, Bernanke received a phone call from former US Treasury Secretary Robert Rubin the following day. That set off a barrage of meetings with market experts including Bridgewater's
Ray Dalio and former Salomon Brothers bond trader and mortgage market pioneer Lewis Ranieri. Was he getting a tutorial on how the structured mortgage market worked?
On August 17
, only 10 days after the FOMC meeting in an unscheduled announcement, the Fed cut the discount rate by 50bps and changed its economic assessment to downside risks to growth due to market
conditions (emphasis my own):
Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward. In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably. The Committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.
After two years of whistling past the housing market graveyard, the immediate policy 180 emitted a sense panic and capitulation. Bernanke would link heightened financial market risk with heightened economic growth risk to justify the abrupt change in policy. This is very important.
Once he moved on the theory that market “uncertainty” increased risk to economic growth, he set a precedent for preemptive
intervention in financial markets whenever the Fed deemed it necessary to “mitigate” increase downside economic risks. This interpretation of the Fed’s mandate is a defining moment in Bernanke’s tenure.
The following six months of FOMC decisions would read like a horror story as it pulled its economic assessment and slashed interest rates 300bps, taking the FF rate to 2.25% by the March 2008 meeting. Bernanke’s dovish reputation immediately began to manifest itself in the market. Despite the risk of slowing growth, discounts for inflation increased significantly. The dollar weakened, commodity prices soared, and the yield curve steepened. Helicopter Ben had demonstrated his inflationary bias. Once he gave the green light, it was clear the market wanted to be in front of the curve.
In August 2007, with the Fed worried about an uptick in inflation pressures, the YOY growth rates in the consumer price index (or CPI) and producer price index (or PPI) were a mere 2.0% and 2.3% respectively. With the dollar falling on the aggressive easing campaign, crude oil and other raw material prices were on the rise. By the spring of 2008, the market’s inflationary discounts began showing up in actual inflation. The March PPI YOY growth rate virtually tripled to 6.7%, pulling the CPI to 4.0%, which was double the rate just six months prior.
Due to the ongoing housing “correction,” this spike in inflation was occurring against the backdrop of sharply slowing growth. In Q3 2007, the YOY growth rate for nominal GDP was 5.2%, which was in line from the previous year -- but by Q2 2008, the rate had dropped to 3.1%. This was a double whammy. On the surface, a 4.0% inflation rate would not seem particularly onerous. But when you measure it against the weak nominal growth, you get a very oppressive rise in prices. The ratio
of CPI to nominal GDP actually showed the 4.0% CPI to be higher relative to economic growth than the double-digit inflation spikes in the 1970s and 1980s. And it would only get worse.
The Fed finally ceased easing in June with the FF rate at 2.0%, giving an assessment of "
diminished downside growth risk; upside risk to inflation" while inflation continued to rise. By July, nominal GDP had flatlined. But with the dollar continuing to deteriorate and oil prices up 100% from a year ago, inflation was delivering a crushing blow to an already teetering economy. The July reading for YOY CPI was 5.6%, but the PPI came in at a whopping 9.9%. Typically the PPI does not exceed the CPI as raw material costs get passed on to the consumer -- and aside from the 1970s, it rarely occurred. This unusual 400bps inversion driven by rocketing commodity prices produced a statistical fat tail.
The most inflation-sensitive market metric outside currency and commodities is the embedded inflation premium in the term structure of the yield curve. Between August 2007 and March 2008, as inflation spiked, so too did the 2YR/10YR spread, steepening dramatically from 50bps to 200bps. This inflation discount wasn’t just occurring in the risk-free curve; it was also seen in the risk curve. Over the same period, the spread in the Moody’s Baa corporate bond index widened from 200bps in August 2007 to 350bps in March 2008.
Most consensus valuation models measure credit and equity risk premiums over the risk-free rate, normally the 10YR Treasury. I have found that a far more consistent benchmark to measure the premium is the YOY growth rate in the CPI. In fact, while the earnings yield on the S&P 500 will routinely trade at a premium to the 10YR yield, it rarely trades through CPI. Going back 40 years, only during the inflation spikes in the mid-1970s and early 1980s did you see the S&P trade through the CPI; the two biggest market tops of the subsequent bull market in 1987 and 2000 actually occurred when the earnings yield equaled the YOY CPI.
In other words, market valuation is much more sensitive to inflation and the discount of inflation than to the actual level of interest rates. In July 2008, the 5.6% CPI spike hit the S&P 500 earnings yield, which I believe was the final straw that broke the market’s back.
At the Jackson Hole symposium on August 31, 2007, Chairman Bernanke gave a speech titled "Housing, Housing Finance, and Monetary Policy
." In this speech, he justified his sudden market epiphany and change in policy.
In the statement following its August 7 meeting, the Federal Open Market Committee (FOMC) recognized that the rise in financial volatility and the tightening of credit conditions for some households and businesses had increased the downside risks to growth somewhat but reiterated that inflation risks remained its predominant policy concern. In subsequent days, however, following several events that led investors to believe that credit risks might be larger and more pervasive than previously thought, the functioning of financial markets became increasingly impaired.
On Friday at the Jackson Hole symposium, exactly five years later, Chairman Bernanke gave a speech titled "Monetary Policy since the Onset of the Crisis
." In this speech, he took a stroll down memory lane and congratulated himself on a job well done (emphasis my own):
When we convened in Jackson Hole in August 2007, the Federal Open Market Committee's (FOMC) target for the federal funds rate was 5-1/4%.
When significant financial stresses first emerged, in August 2007, the FOMC responded quickly, first through liquidity actions--cutting the discount rate and extending term loans to banks--and then, in September, by lowering the target for the federal funds rate by 50 basis points. As further indications of economic weakness appeared over subsequent months, the Committee reduced its target for the federal funds rate by a cumulative 325 basis points, leaving the target at 2% by the spring of 2008.
Despite the easing of monetary policy, dysfunction in credit markets continued to worsen.
Responded quickly? When financial stresses first emerged in August? Hmmm... That’s a bit of a stretch.
It is my belief that dysfunction in credit markets continued to worsen not despite
the easing of monetary policy but because
of the easing of monetary policy. Initially, the housing and mortgage crisis was contained to those markets. It was not until the Fed opted to forego its inflation risk bias in favor of liquidity support for those markets that the crisis spread. The further the FF rate dropped below the rate of inflation, the wider the inflation discount and thus risk premiums became.
The 2008 crash didn’t happen because people quit paying their mortgages. It happened because of a rapid repricing of risk premiums in highly leveraged (short volatility/short gamma) positions due to a spike in inflation discounts that drove an eventual spike in implied volatility. The correlations between the dollar, commodity prices, the yield curve, and the risk curve are undeniable.
At Jackson Hole, Chairman Bernanke defended the Fed’s policy of inflating. By all accounts, the Fed is prepared to do more. In the aforementioned 2002 speech "Deflation: Making Sure 'It' Doesn’t Happen Here,"
Bernanke lays out his playbook for fighting deflation and thus far he’s been operating according to plan. However, it’s the following quote that perhaps did the most damage to his reputation in the market, which has impaired his ability to effectively employ his monetary tools (emphasis my own):
But the US government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many US dollars as it wishes at essentially no cost. By increasing the number of US dollars in circulation, or even by credibly threatening to do so, the US government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services.
That is an academic speaking, not an investor. An academic can draw it up on the chalkboard and everything works out just fine. An investor has to deal with the volatility of the market discount. There may not be a cost to an academic, but there is a cost to an investor. The cost is inflation. Nowhere is that more evident than in the present market volatility.
But the folly in Bernanke’s cost/benefit logic is not just in the market cost; it’s in the economic cost. Perhaps there is no more tragic statistic since the financial crisis than what was reported by Sentier Research
regarding real income. From a Bloomberg
story (emphasis my own):
Median household income fell 4.8% on an inflation-adjusted basis since the recession ended in June 2009, more than the 2.6% drop during the 18-month contraction, the research firm’s Gordon Green and John Coder wrote in a report today.
That’s astonishing. How can you explain a drop in inflation-adjusted income other than as a result from the Fed’s campaign to engineer higher inflation? This is not some academic policy exercise given on a chalkboard; this is real, and it is crushing middle class consumers who are the backbone of our economy.
The most important legacy of the Bernanke Fed is the interpretation of the duel mandate as it applies to markets. Since August 2007, Bernanke has been willing to intervene in markets when he thinks economic growth is at stake; however, he has not been willing to intervene in markets when inflation is at stake. This is critical to understanding why markets have been so volatile. Contrary to what consensus assumes, risk premiums and multiples are not a function of growth; they are a function of inflation and inflation discounts. As long as the Fed focuses on growth at the expense of inflation, the market will continue to price risk premiums accordingly.