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US Monetary Policy at a Crossroads: Ben Bernanke Has a Decision to Make


Or is Bernanke trying to send the market a message that he is indeed targeting nominal GDP without admitting it?

Bernanke didn't want to explicitly launch a nominal GDP target because he instead wants to stick to their employment mandate, but in his mind he probably thought it was implicitly the same. However it's not working out that way. Payrolls are not generating an increase in aggregate demand. This poses a conundrum for the Fed because we could conceivably reach their unemployment rate threshold without nominal growth. This could force the Fed to back off stimulus with the economy close to a recession. This would continue to pressure real interest rates at the most inopportune time, risking the very deflationary spiral monetary nightmare every central banker fears.

Bernanke admitted that the Fed launched a new policy initiative when they introduced threshold guidance in lieu of date guidance. However when they opted to perform an ex post cost benefit analysis on the program, they admitted they weren't fully committed to go all the way, which presents a credibility problem. This has the market very confused and upside down, destroying their ability to produce long term inflation expectations which is key to producing low real rates. Ironically the threshold guidance is meant to be more transparent, however the economic results between employment and aggregate demand are diverging creating a very difficult environment in which to position bond portfolios.

There are a lot of experts who know how to conduct monetary policy when interest rates are at the zero bound, but no one has successfully pulled it off. This threshold-based policy is supposed to raise inflation expectations to lower real rates in order to stimulate aggregate demand. However since open-ended inflation target QE III was initiated, softening aggregate demand has lowered inflation expectations, which are raising real rates. The economic forecast policy evolution that Bernanke cited last week is actually backfiring. Is the Fed really going to taper into decelerating growth? They have a very big decision to make and it's not clear how the market will react.

Legend has it that Robert Johnson went down to the crossroads and sold his soul to the devil to become the greatest blues musician. It worked. Johnson is regarded as the king of the blues and his music is the foundation of rock 'n' roll. Renditions of his songs went on to be recorded by Cream, the Allman Brothers, the Grateful Dead, Led Zeppelin and the Rolling Stones.

I think monetary policy is now at the crossroads of employment and aggregate demand. In exchange for a more rapid reduction in unemployment, the Fed made their own deal with the devil when they changed policy, opting for threshold guidance. The problem is they adopted the policy but chose the wrong threshold, and the market doesn't know what to trade. The result is a lack of conviction, a lack of liquidity, and increased volatility. I'm just standing at the crossroad and believe I'm sinking down….

Twitter: @exantefactor
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