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Helicopter Ben Rides Again


As long as the Fed focuses on growth at the expense of inflation, the market will continue to price risk premiums accordingly.


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.

Twitter: @exantefactor
No positions in stocks mentioned.
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