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Bernanke, Right On Cue


As we highlighted here yesterday, Fed Governor Bernanke gave a speech on disinflation. Below are some of the more relevant headline's that crossed my Bloomberg:

"Monetary Ease Needed for Considerable Time"
"Disinflation May Continue Even If Growth Rises"
"Fed Should Be Willing To Cut Rates To Zero"
"Higher Bond Yields Not Significant Threat"
"Further Rate Cuts Would Still Affect Economy"
"US Is Experiencing Jobless Recovery Like 1991"

Bernanke's speech, which you can, and should, read here, didn't cover any substantially new ground in the Fed's thinking about deflation, as the headline's above suggest. Bonds were well bid and the dollar was hit hard on the above headlines ("considerable time" and "cut rates to zero" probably had something to do with that). Stocks had no real reaction.

There were a few things in the written text that I think are important to highlight. First, Bernanke goes to pains to suggest that disinflation and deflation are two different things entirely: "a disinflation (a decline in the rate of inflation) and a deflation (a falling price level) are not necessarily the same thing." This, of course, is a distinction without a difference.

Two paragraphs later, however, he admits that "no sharp discontinuity exists at the point that measured inflation changes from positive to negative values. Very low inflation and deflation pose qualitatively similar economic problems". Which, of course, is the whole point of worrying about disinflation anyway, because its effect on the financial system and on economic recovery is the same if disinflation is present as outright deflation.

Bernanke then lays out the textbook reasons why deflation is potentially harmful to an economy: "deflation can be particularly harmful when the financial system is already fragile, with household and corporate balance sheets in poor condition and with banks undercapitalized and heavily burdened with nonperforming loans."

As per other Fed officials, he goes on to prove how these three conditions aren't present in our economy: "Both households and firms have done excellent jobs during the past few years of restructuring and rationalizing their balance sheets...households have taken advantage of low interest rates to refinance their mortgages...firms have lengthened the maturities of their debts, lowered their interest-to-earnings ratios, and improved their liquidity...the U.S. banking system is highly profitable and well-capitalized and has managed credit risk over the latest cycle exceptionally well."

Notice that Governor Bernanke has focused solely on the ability of companies and consumers to service their debt and has no words about the potential negative effects of absolute debt loads either at the consumer or corporate level. Both are at significant highs, and the long term implications of such high debt loads are worrisome unless economic growth accelerates substantially.

Perhaps the most honest part of the speech was the following: "In the worst-case scenario...Suppose that initially short-term nominal interest rates were already near zero and prices were falling. If aggregate demand was sufficiently low relative to potential supply, deflation might grow worse, as economic slack led to more aggressive wage- and price-cutting. Because the short-term nominal interest rate cannot be reduced further, worsening deflation would raise the real short-term interest rate, effectively tightening monetary policy. The higher real interest rate might further reduce aggregate demand, exacerbating the deflation and continuing the downward spiral. That, at least, is the theoretical possibility."

Um, aren't short term interest rates, at 0.75% already pretty "near zero"? Aren't "prices falling" according to the core CPI and PPI data? Isn't "aggregate demand sufficiently low relative to potential supply" - check capacity utilization rates for example. Of course, he, states, as Greenspan did at his Humphrey Hawkins testimony, that rates can still be cut from 0.75%. But the question isn't whether they can be cut but what those cuts will accomplish. It is clear that Fed Funds rate reductions have already gotten to the point of diminishing returns: each cut has had less and less stimulative effect on demand.

And that brings us to alternative policy tools, and Governor Bernanke laid out the most detail to date about what the Fed could do if they believe adjusting the Fed Funds rate won't have the intended effect on the economy: "a commitment by the FOMC to keep short-term yields at a very low level for an extended period...together with...increased purchases of longer-term government bonds by the Fed, an announced program of oversupplying bank reserves, term lending through the discount window at very low rates, and the issuance of options to borrow from the Fed at low rates."

Man, the possibility of the Fed issuing treasury puts. Does that make your spine stiffen like it does mine?

No matter where you stand on the debate over deflation (and it isn't today's business), the most important immediate aspect of these disinflationary forces is the lack of pricing power, which affects the ability of corporations to generate meaningful revenue growth. In an environment where revenue growth stagnates, cost cutting is necessary to achieve better-than-peer earnings growth (and what Board of Directors isn't focused on that?). And even then, cost cutting only goes so far (just ask the union-dominated airline and auto industries).

Of course, you know stocks are already pricing in an economic rebound of considerable (revenue-lead) proportion. In an environment where pricing power is absent (and overcapacity rules - see Worldcom's metamorphosis into MCI), such valuation extremes are unsustainable.

Whether we just slog along at sub-par economic growth rates for the rest of the decade or retrench into some economic recession far more severe is largely a function of how the deflationary forces evolve. If we get into that "theoretical" downward spiral that Governor Bernanke spoke about above, things could get awfully ugly. If the liquidity that the Fed has built up holds off those deflationary forces, the best we can hope for is economic stagnation for a very long time, as capacity is rationalized and the asset bubble excesses of the 90s worked off.

The "downward spiral" scenario suggests new lows - substantial new lows - in stocks. Long term stagnation means selling overbought and buying oversold in a wide trading range. Either outcome means stocks are vulnerable here. Mighty vulnerable.
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