Thursday, July 22, 2010

Mr. Bernanke In a Bind...(and a footnote on Europe)

Mr. Bernanke's testimony before the Senate Banking Committee yesterday has already received an abundant amount of coverage, both in the media and among market professionals- so, there is not much particularly insightful that can be added at this point.

Still, his comments with regard to a specific topic during his testimony merit a few special observations, as they also relate directly to the heart of an article we published in this space a few days ago (

During the Q&A, the Fed Chairman was asked by Senator Jim Bunning (R, Kentucky) whether the Fed is "out of bullets" to use in order to help strengthen the underwhelming economic recovery. His reply was "Well, I don't think so. We need to continue to evaluate those options. As I said, we are not prepared to take any specific steps in the near term, particularly since we're still also evaluating the recovery, the strength of the recovery. But I do think that there is some potential for some of those steps to be effective" (italics added for emphasis).

His triple-qualified answer can hardly be viewed as an expression of confidence in the Fed's ability to actually do much at this point. Gone are the days where he was vigorously emphasizing the Fed's nearly unlimited arsenal of policy-making tools, including the infamous metaphor about helicopters throwing money into the economy from the sky- already done, and it has not worked.

Mr. Bernanke proceeded to enumerate some of those options (paying less interest on bank reserves, bolstering the Fed's language committing to keep rates low for an extended period, not allowing maturing securities to run off of its balance sheet, or embark on more asset purchases), while adding conspicuously that "...they are not going to be conventional options, so we need to look at them carefully and make sure we are comfortable with any step that we take".

While the true effectiveness of some of these measures can be called into question outright (see the first of the above links to our recent article), all of them do include considerable risks for the Fed, which make these options even less appealing on a cost-effective basis. For example, if the Fed were to engage in another round of asset purchases- massive enough to have any perceptible effect, to the tune of 30-40 basis points on market rates- it would create enormously bigger complications for its ultimate exit strategy, as it would then require the absorption of a much bigger amount of liquidity than what is currently the case. Or, it would reflect a certain degree of disconnect from the reality on the ground to argue that the Fed's elimination of the interest rate it now pays banks on their excess reserves (25 basis points) would have an effect on bank lending standards and/or economic activity; bank lending standards are not so tight because there is not enough liquidity in the system. In fact, the banking system is already swimming in reserves.

The truth is that Mr. Bernanke has probably run out of credible options to activate in order to help the economy, and this was the subtext to his highly cautious answer to that question during his testimony yesterday. Any of the remaining options are of questionable effectiveness, fraught with more risks than any potential benefit they offer.

The Fed Chairman, understandably, could not acknowledge that in public. However, his appreciation of the bind the Fed is in makes it rather unlikely that the Fed will proceed with the implementation of any such additional "stimulative" measures. If the economic recovery remains stuck on a 3% path over the net few quarters, the pressure on the Fed will be building to show that it is taking some action to alleviate the stubbornly high unemployment rate. Our guess is that Bernanke will be inclined to resist the activation of such additional steps of mostly cosmetic value and will simply prescribe patience for the economic recovery's dynamic to pick up steam over time.

For now, one thing is almost certain: that the "extended period" language is safe over the coming months.

(A brief note on Europe)
Two key economic reports coming out of Europe this morning surprised with their vigor and raise some questions about the widely anticipated slowing in economic activity there due to the fiscal austerity situation.

Eurozone's industrial orders surged 3.8% (month-to-month) in May, following a 0.6% gain in April. In the three-month period to May, orders are up 8.5% versus an increase of 5.8% in the three-month period to April. ( To alleviate any skepticism that this report was for May, and therefore less relevant to the period immediately following the peak of the fiscal crisis in the spring, the Eurozone's July manufacturing PMI rose to 56.5 from 55.6 in June. The service sector PMI for the bloc also rose in July to 56.0 from 55.5 in June. The strength in both PMIs for July was particularly pronounced in the data for Germany.

It may admittedly be too soon for any slowing in economic activity in Europe, as a result of the fiscal austerity policies in place, to be reflected in the July data yet. However, what these reports show is that two months after the peak of the fiscal turmoil that shook the Eurozone countries, economic growth in the bloc still has respectable forward momentum that may withstand better than originally assumed by many the fiscal policy headwinds.

Anthony Karydakis

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