Sunday, January 3, 2010

Is it Possible Bernanke has Seen the Light?

Marc Faber calls him a dangerous inflationist. Nassim Taleb likens him to an arsonist who now has the task of putting out the fire he started. Despite his mild mannered, soft spoken nature, could Ben Bernanke and his seemingly religious beliefs about financial markets be long term threats to the stability of the US? In general, I worry that his willingness to monetize the US debt has put us on a path to uncomfortable levels of inflation. But, from his comments this morning (as covered by the Associated Press and printed in the NY Times) to members of the American Economic Association, there may be some hope that the events of the past few years have taught him something about the dangers of misguided monetary policy.

First, when I read the headline in the Times I almost fell out of my chair. The article is titled "Bernanke Calls for Regulation to Fight Future Bubbles." Say what??!! You mean that the guy who basically said he did not believe in bubbles was actually advocating some kind of policy response to prevent bubbles? If true, this would be tantamount to Alan Greenspan's recent admission that the financial meltdown had proved to him that the entire framework from which he had viewed financial markets during his career was wrong. That statement is still shocking to me in terms of its magnitude. Kind of like a Minsky Moment, I would deem this a Greenspan Moment. For me, that would be like Warren Buffett, Ben Graham and Seth Klarman being exposed as Bernie Madoff-like frauds. If value investing turned out to be nothing more than an elaborate, multi-generational Ponzi scheme I'm not sure what I would do. I can assure you that getting out of bed the next morning would not be particularly easy.

Could Bernanke really have come to a commensurately game changing realization? I was skeptical but I had to find out. Fortunately, as investors we are blessed by the Fed’s never ending desire to be transparent and the speeches by the Fed governors are posted on its website. Bernanke’s speech starts off in a promising way (for those of us who want to Fed to understand the potential disastrous effects of its decisions):

“Even as we continue working to stabilize our financial system and reinvigorate our economy, it is essential that we learn the lessons of the crisis so that we can prevent it from happening again. Because the crisis was so complex, its lessons are many, and they are not always straightforward. Surely, both the private sector and financial regulators must improve their ability to monitor and control risk-taking. The crisis revealed not only weaknesses in regulators' oversight of financial institutions, but also, more fundamentally, important gaps in the architecture of financial regulation around the world. For our part, the Federal Reserve has been working hard to identify problems and to improve and strengthen our supervisory policies and practices, and we have advocated substantial legislative and regulatory reforms to address problems exposed by the crisis.”

Promising, but not particularly introspective. This paragraph seems to imply that the Fed sees itself as an evaluator of the failures of other agencies and the legislative body as opposed to a willing participant in all of the bubble era madness. This type of dissociation from the systemic problems that have emerged recently is clearly troubling and indicates an unwillingness to seriously examine what role the Fed played in creating the housing bubble and allowing financial institutions it was supposed to be regulating to become levered to the hilt.

“Some observers have assigned monetary policy a central role in the crisis. Specifically, they claim that excessively easy monetary policy by the Federal Reserve in the first half of the decade helped cause a bubble in house prices in the United States, a bubble whose inevitable collapse proved a major source of the financial and economic stresses of the past two years. Proponents of this view typically argue for a substantially greater role for monetary policy in preventing and controlling bubbles in the prices of housing and other assets. In contrast, others have taken the position that policy was appropriate for the macroeconomic conditions that prevailed, and that it was neither a principal cause of the housing bubble nor the right tool for controlling the increase in house prices.”

At least he understands the criticisms that have been thrown so vigorously at the Fed from a wide range of politicians, economists, bloggers and market professionals. Personally, I agree with Bernanke to some extent that interest rate policy may not be the best tool for popping or preventing asset bubbles. To me that would be like trying to tee off with a baseball bat; good luck trying to precisely drive the ball. Unfortunately for the Fed, this does not absolve the members of responsibility for allowing the housing bubble to inflate so dramatically as the Fed was one of the primary institutions in charge of curbing predatory lending and excessive balance sheet growth. Also, with the benefit of hindsight I think it is very hard to argue that the excessively low interest rates in the early part of the decade were appropriate given the macroeconomic circumstances. I am not an economist but it seems logical that historically low interest rates, especially those stemming from the zero interest rate policy in place now, should only be used in very dramatic circumstances.

Not to downplay the significance of the impact of the September 11th attacks or the bursting of the tech bubble but I am unsure that a response to those events that included leaving interest rates under 2% from December 2001 to December 2004 was justified. Bernanke exhausts a lot of energy attempting to defend the monetary policy of this period by citing low inflation and a jobless recovery as contributing factors as well as illustrating how the Taylor Rule that indicated that rates were too low was not the perfect metric. However, my focus is not to admonish the Fed leaders for past mistakes, especially since Bernanke did not become Chairman until 2005. My concern is simple: until the Fed is willing to recognize that there are severe risks to leaving interest rates at depressed levels for an extended period it is likely to continue to play a major part in what I see as a particularly negative perpetual boom and bust prone US economic model.

“To set the stage for the discussion, Slide 5 shows the annual increase in nominal house prices from 1978 to the present.11 After some years of slow growth, U.S. house prices began to rise more rapidly in the late 1990s. Prices grew at a 7 to 8 percent annual rate in 1998 and 1999, and in the 9 to 11 percent range from 2000 to 2003. Thus, the beginning of the run-up in housing prices predates the period of highly accommodative monetary policy. Shiller (2007) dates the beginning of the boom in 1998. On the other hand, the most rapid price gains were in 2004 and 2005, when the annual rate of house price appreciation was between 15 and 17 percent. Thus, the timing of the housing bubble does not rule out some contribution from monetary policy.”

Hmmm, in 2004 and 2005 housing prices were growing at more than twice the rate seen in 1998 and 1999 and at least one and a half times the rates seen in 2000-2003? Shouldn’t that have been a sign that the housing market was getting a bit frothy? Maybe, according to Bernanke, but in his mind the magnitude of increase had nothing to do with monetary policy. Instead he blames it on poor underwriting standards and exotic mortgage products:

“With respect to the magnitude of house-price increases: Economists who have investigated the issue have generally found that, based on historical relationships, only a small portion of the increase in house prices earlier this decade can be attributed to the stance of U.S. monetary policy.12 This conclusion has been reached using both econometric models and purely statistical analyses that make no use of economic theory…”

“The picture that emerges is consistent with many accounts of the period: At some point, both lenders and borrowers became convinced that house prices would only go up. Borrowers chose, and were extended, mortgages that they could not be expected to service in the longer term. They were provided these loans on the expectation that accumulating home equity would soon allow refinancing into more sustainable mortgages. For a time, rising house prices became a self-fulfilling prophecy, but ultimately, further appreciation could not be sustained and house prices collapsed. This description suggests that regulatory and supervisory policies, rather than monetary policies, would have been more effective means of addressing the run-up in house prices.”

Also, Bernanke argues that since housing prices were increasing across the globe during this period, if low rates were the culprit we would expect to see a similar impact across countries. According to Bernanke the data does not support a correlation between monetary policy and housing appreciation but does support a relationship between a global savings glut (and the associated capital inflows from emerging markets) and housing booms:

“As Slide 9 shows [click through to see all of Bernanke’s slides], the relationship between the stance of monetary policy and house price appreciation across countries is quite weak. For example, 11 of the 20 countries in the sample had both tighter monetary policies, relative to the standard Taylor-rule prescriptions, and greater house price appreciation than the United States. The overall relationship between house prices and monetary policy, shown by the solid line, has the expected slope (tighter policy is associated with somewhat slower house price appreciation). However, the relationship is statistically insignificant and economically weak; moreover, monetary policy differences explain only about 5 percent of the variability in house price appreciation across countries.

What does explain the variability in house price appreciation across countries? In previous remarks I have pointed out that capital inflows from emerging markets to industrial countries can help to explain asset price appreciation and low long-term real interest rates in the countries receiving the funds--the so-called global savings glut hypothesis (Bernanke, 2005, 2007)… The downward slope of the relationship is as expected--countries in which current accounts worsened and capital inflows rose (shown in the left half of the figure [see Slide 10]) had greater house price appreciation over this period.18 However, in contrast to the previous slide, the relationship is highly significant, both statistically and economically, and about 31 percent of the variability in house price appreciation across countries is explained.19

Based on all of this fancy statistical data, Bernanke draws the following conclusions:

My objective today has been to review the evidence on the link between monetary policy in the early part of the past decade and the rapid rise in house prices that occurred at roughly the same time. The direct linkages, at least, are weak. Because monetary policy works with a lag, policymakers' response to changes in inflation and other economic variables should depend on whether those changes are expected to be temporary or longer-lasting. When that point is taken into account, policy during that period--though certainly accommodative--does not appear to have been inappropriate, given the state of the economy and policymakers' medium-term objectives. House prices began to rise in the late 1990s, and although the most rapid price increases occurred when short-term interest rates were at their lowest levels, the magnitude of house price gains seems too large to be readily explainable by the stance of monetary policy alone. Moreover, cross-country evidence shows no significant relationship between monetary policies and the pace of house price increases…

The lesson I take from this experience is not that financial regulation and supervision are ineffective for controlling emerging risks, but that their execution must be better and smarter. The Federal Reserve is working not only to improve our ability to identify and correct problems in financial institutions, but also to move from an institution-by-institution supervisory approach to one that is attentive to the stability of the financial system as a whole. Toward that end, we are supplementing reviews of individual firms with comparative evaluations across firms and with analyses of the interactions among firms and markets. We have further strengthened our commitment to consumer protection. And we have strongly advocated financial regulatory reforms, such as the creation of a systemic risk council, that will reorient the country's overall regulatory structure toward a more systemic approach. The crisis has shown us that indicators such as leverage and liquidity must be evaluated from a systemwide perspective as well as at the level of individual firms…

That said, having experienced the damage that asset price bubbles can cause, we must be especially vigilant in ensuring that the recent experiences are not repeated. All efforts should be made to strengthen our regulatory system to prevent a recurrence of the crisis, and to cushion the effects if another crisis occurs. However, if adequate reforms are not made, or if they are made but prove insufficient to prevent dangerous buildups of financial risks, we must remain open to using monetary policy as a supplementary tool for addressing those risks--proceeding cautiously and always keeping in mind the inherent difficulties of that approach. Clearly, we still have much to learn about how best to make monetary policy and to meet threats to financial stability in this new era. Maintaining flexibility and an open mind will be essential for successful policymaking as we feel our way forward.

And there folks, highlighted above, seems to me to be a bombshell. Just the hint that monetary policy could be used in the future to address the risks associated with asset bubbles appears to indicate a very positive evolution in the thinking of the Fed Chairman. Over the last year I have read the majority of his speeches and correct me if I am wrong, but I do not recall him ever been this forthcoming and open to adjusting Fed strategy when it comes to asset bubbles. Was this Bernanke’s Greenspan moment? Does this mean the Fed is going to be much more aggressive in raising interest rates this time around? Are those worried about rampant inflation or even hyperinflation going to be proven wrong as a result of a new Volcker-like philosophy coming from Bernanke? I am skeptical based on his historical bias towards inflation, his extreme fears of deflation, his desire to prevent another deflationary Depression, his staunch defense of past Fed looseness, and his beliefs about the impact of monetary policy on the housing bubble. But, those final words provide me with a modicum of hope that I sure did not have when I woke up this morning. Maybe 2010 is going to be a better year than I have been anticipating.