Bernanke Calls for Fiscal Responsibility

[Frodo]

Fed Chief Calls for Plan to Curb Budget Deficits

BY JACK HEALY
Published: June 3, 2009

The Federal Reserve chairman, Ben S. Bernanke, said on Wednesday that the United States needed to develop a plan to restore fiscal balance, even as the government racks up huge budget deficits as it tries to spend its way out of the worst economic crisis since the Great Depression.

In remarks to the House Budget Committee, Mr. Bernanke said that the government must address the immediate problems of a crippling recession that has erased trillions of dollars in household wealth, hobbled people’s stock portfolios and raised unemployment to its highest levels in a generation. Still, he said, the government needed to think about putting its fiscal house back in order.

“Unless we demonstrate a strong commitment to fiscal sustainability in the longer term, we will have neither financial stability nor healthy economic growth,” he said in prepared remarks.

The deficit is expected to reach $1.8 trillion this year as the country spends feverishly on financial bailouts, a sweeping stimulus package, lending programs, rescues for the automobile industry and more. Those are the highest budget deficit projections as a share of gross domestic product since World War II.

President Obama has vowed to reduce the budget gap by half by the end of his term, a promise made even as tax revenue is falling and the administration is trying to cobble together a potentially costly overhaul of the health care system. And the country faces trillions more in Social Security and Medicare obligations as baby boomers retire in coming years.

“Even as we take steps to address the recession and threats to financial stability, maintaining the confidence of the financial markets requires that we, as a nation, begin planning now for the restoration of fiscal balance,” Mr. Bernanke said.

Lately, financial markets have started to quaver on worries about the government’s spending plans, and how they are piling more obligations onto the country’s $11 trillion national debt.

Investors in the bond markets, where the Treasury Department goes to raise money to keep the government running, are getting skeptical about the scale of Washington’s spending. The yields on Treasury notes have risen to their highest points in five months as investors who thronged to the safety of government debt begin to invest their money elsewhere.

“These increases appear to reflect concerns about large federal deficits but also other causes, including greater optimism about the economic outlook, a reversal of flight-to-quality flows, and technical factors related to the hedging of mortgage holdings,” Mr. Bernanke said.

But Mr. Bernanke made no mention of whether the Fed would increase its purchases of $300 billion worth of government securities. Such a move could help to push down interest rates on longer-term Treasury notes, but it could raise the prospects for inflation down the road.

The movement away from Treasuries, which rose to record prices at the height of the credit crisis, is a good thing on some levels. It suggests that investors are becoming more confident in riskier investments like stocks and corporate bonds.

But rising interest rates on Treasury notes make it costlier for the government to raise money. And higher yields on government debt can also push up interest rates on mortgages and other loans, making borrowing more expensive for consumers and homeowners.

In his testimony, Mr. Bernanke said that some corners of the once-frozen financial markets were edging toward normal. Major banks deemed in need of additional capital are raising money by issuing billions in common stock and notes, and markets for short-term loans among banks are functioning more smoothly, Mr. Bernanke said.

He noted that some financial institutions are weaning themselves off government-backed loan programs as they seek to pay back the money they took under the $700 billion financial bailout.

“It is encouraging that the private sector’s reliance on the Fed’s programs has declined as market stresses have eased, an outcome that was one of our key objectives when we designed our interventions,” he said.

Mr. Bernanke again cited numerous flickers of stability and growth in the economy and said that the economy’s swift declines were slowing and predicted growth would resume later this year. But he swatted away any hopes of a swift recovery, and said that the economy would probably continue to heal slowly.

“We expect that the recovery will only gradually gain momentum and that economic slack will diminish slowly,” he said in his remarks. “In particular, businesses are likely to be cautious about hiring, and the unemployment rate is likely to rise for a time, even after economic growth resumes.”

[Sam Spade]

lol

[Beet]

Of course he (and Obama) must signal that he is concerned about this. But it hardly improves their real position.

[Swing low, sweet chariot. Comin' for to carry me home.]

BB gave responsible remarks: short term spending was necessary to save economy from immediate depression, but long term spending needs to reigned in.

[Sam Spade]

Of course he (and Obama) must signal that he is concerned about this. But it hardly improves their real position.

Maybe.  But in the end, letting the debt deflation continue is the road I think BB will take when faced with the fork in the road at some point in the near future (I reserve my right to change this opinion in the future, but I believe it will occur because the bankers are close enough to getting enough capital to survive it - unsure on this point too yet - need to examine books).  What Obama wants to do creates a wildcard in my call, as he is less influenced by the "math" and more influenced by the best political solution.

Anyway, the key question here in my mind is when will BB pull liquidity from the market again?  Is this a warning shot or just misinformation?

http://www.marketwatch.com/story/time-for-fed-to-start-tightening-hoenig-says

I don't think it's going to happen yet, as I still think there's another leg up in the market sometime later this month and maybe into July, but a speculative dollar play may soon be called for (and I might do it now).  As well as some long term puts (if cheap)

I lol because Bernanke is perhaps the biggest spender around, especially in his purchase of agency MBS, which are completely toxic and now one else wants to touch.

[opebo]

But in the end, letting the debt deflation continue is the road I think BB will take when faced with the fork in the road at some point in the near future.

Why do you think he will do this?

[Beet]

BB prefaced his comments with a firm statement about the need to take measures to reverse debt-deflation in the short term. In his more widely reported comments, he was talking about "planning" for a restoration of fiscal balance in the "long term"- hardly a controversial statement. He also laid out some undisputed facts about entitlement programs where it is clear he is looking at a 10- or 20- year horizon. Bernanke also attributed the rise in the long bond  yields to "concerns about large federal deficits but also other causes, including greater optimism about the economic outlook, a reversal of flight-to-quality flows, and technical factors related to the hedging of mortgage holdings."

Expected inflation has risen to only 1.6%, as Martin Wolf points out, while actual inflation is still the lowest since 1955... worse in the eurozone. So no, I'm not expecting inflation any time soon, and I don't think the Fed is either.

Taken in light of today's worse- than expected numbers, continued rapid decline in the job market, and Bernanke's comments, Hoenig's comments seem quite strange. I would be very surprised if the Fed chose debt- deflation over further easing if it came down to the wire and obviously, I think it would be the wrong move. The only thing that could give them pause in that regard would be the risk of capital flight.

[CARLHAYDEN]

Bernake lecturing Congress about "Fiscal Responsibility" is like Bernie Madoff lecturing a shoplifter about the evils of theft,

I hope Congress passes and implements the legislation forcing the fed to open its books.

[Sam Spade]

Taken in light of today's worse- than expected numbers, continued rapid decline in the job market, and Bernanke's comments, Hoenig's comments seem quite strange.

It's jawboning.  I don't believe it one bit.  But there's plenty of reasons why it is being said.

You must be logged in to read this quote.

This is certainly a subject I could go on for quite a while now.

Look, the Fed, if there were no consequences, would choose to inflate until the cows come home.  But that's not the way things work, since there are consequences.

In reality, the Fed is trying to keep every part of the economy propped up while maintaining a certain "artificial" environment that it believes stands the best chance of turning things around.  To use an analogy, the Fed is attempting to be Atlas, holding the world (or at least mostly the US) up on his shoulders.  We may include other countries in this analysis, but that's not important.

To achieve this end, the Fed is injecting huge amounts of liquidity into the market, buying up MBS and Treasuries (long-end) to keep those yields down, maintaining a ZIRP on the short-end, buying up various companies, injecting huge amounts of stimulus into economy, etc., etc. (and yes, I know a lot of this is not really the Fed since a lot of it ends up at Treasury). 

Anyway, I have long maintained that this "juggling act" is unsustainable (I cannot come up with a scenario where it isn't in the present circumstances without the fundamentals showing improvement that they are clearly not - "pumping" to the contrary) and will eventually fall apart, but its the sequence and timing which is so difficult.

The Fed faces two large issues that are brewing at this point.  First, the liquidity the Fed is pumping into the market is ending up in commodities and stock speculation, but commodity speculation is the big problem.  More importantly, the 10-year bond yield and mortgage rates (which closely track) have gone down significantly recently.  A 1% rise of mortgage rates within the span of a couple of weeks has a huge impact on the housing market, not to mention refis (probably much worse there).

The Fed cannot allow this to happen for a whole host of reasons and has been jawboning (and buying like crazy) to keep these rates down.  I suspect the next game is going to be pulling liquidity from the market to force money into the 10-year (thusly driving mortgage rates down).  Obviously, we know what this will do to the stock market and commodities.  I am also seeing renewed weakness in the credit markets, which makes sense if an attempt to remove liquidity is starting to occur (since the Fed is doing a lot of indirect propping there too).

jmfcst asked me about what I see concerning the end game a few days ago and it leads from the above paragraph quite nicely.  When the Fed pulls liquidity from the market and the money drives into the short-term bonds not the long-term bonds (i.e. 10-year keeps rising), the end game is at hand.

I don't think this "pull" will be it, but we have to keep our mind open.  We also have to keep our mind on the fact that, even though I'm seeing a lot of signs of topping in a number of areas, there may still be higher to go yet, especially in the stock market.  Markets can behave irrationally longer than the players can stay solvent.

I just realized that I went "off" for a while and didn't answer your question...    I did kind of get at when I think BB will stop the easing in the above two paragraphs because I think this is the point when he bails.  But maybe I'm wrong.  If we continue along this path at that point, the end results are not good and become up for interpretation...

All opinions expressed above are the author's and likely not held by anyone else at this site.

[opebo]

I suspect the next game is going to be pulling liquidity from the market to force money into the 10-year (thusly driving mortgage rates down).  Obviously, we know what this will do to the stock market and commodities. 

So this is your end game?  Why, if the fed wishes to 'force money' into the 10-year, thus driving rates down, would it use the incredibly round-about and backwards method of 'pulling liquidity from the market'?

Why not simply buy the 10-year or even mortgages directly with printed money?

[Beet]

I suspect the next game is going to be pulling liquidity from the market to force money into the 10-year (thusly driving mortgage rates down).  Obviously, we know what this will do to the stock market and commodities. 

So this is your end game?  Why, if the fed wishes to 'force money' into the 10-year, thus driving rates down, would it use the incredibly round-about and backwards method of 'pulling liquidity from the market'?

Why not simply buy the 10-year or even mortgages directly with printed money?

Sigh. Because then you would be monetizing the debt. And when you do that too much there is a risk of capital flight. The Federal flow of funds statement and some analysis by Brad Setser over at the Council on Foreign Relations have shown that the foreign central banks have changed their dollar investment behavior by moving out of the long bond (10- year, 30-year maturity) and into 3- month t-bills. They have also moved (understandably or not) out of agency debt (Fannie and Freddie debt). The Chinese are making noises. If you want to call them on it fine, but monetizing the debt is just another way of defaulting, it merely spreads the pain around from the financial sector or whomever the government is helping to all dollar holders, in the form of a lower exchange rate. The United States has more room to do this than a developing country, of course, as developing nations who have experienced crises and tried to print their way out have learned in the past. But the rules of the game still apply, only are more of a distance, to the United States and our policy makers are aware of this.

If investors were really confident in the credit markets, then you would see money move out of the 3- month t-bill and into places where they can get a higher return. For example the corporate bond market. But although almost every other credit indicators has improved this spring, that one has not; the yield curve remains stubbornly widening.

The demand for long term bonds depends on three factors as I stated a few months ago- the risk of default (which if you believe the Markit numbers which of course are based on voluntary self-reporting, it composes about 40 basis points), inflation expectations over the maturity of the security (which if you look at the 10 year, is the difference between the 10 year Treasury and the 10 year TIPS; ignoring tax differences for now; and is about 200 basis points and up significantly just this month; when Martin Wolf wrote the article I linked to above it was only 160), and finally, the opportunity cost of other investments, (which again if you look at the 380 close of the 10 year, 380-40-200 comes out to about 140 basis points).

But you cannot determine the price of a bond simply by looking at these three factors alone: these factors only determine, within a fixed level of depth of the capital markets, what your demand curve is. At every level of the demand curve, the price is determined by the intersection point with the supply curve. And the supply curve has been ballooning due to the cost of the government stimulus, bailouts, the rising cost of unemployment insurance, Federal facilities, and Obama's programs. This has put pressure on the long term yield curve which sets rates not only for the housing market but serves as the starting level for most private interest rates; hence the government is literally starting to crowd out private lending and Bernanke has been concerned enough about this to start making noises (or 'jawboning' if you like, which implies some sort of threat that I'm going to start being mean if you don't buy) to the effect.

As an amusing side-note, the same thing happened to Clinton in the 1990s when he tried health care reform.

But the more fundamental problem is that the government cannot create value in and of itself; it can only move things around, which is fine when the markets have stopped working or 'abdicated their temple' as FDR has put it, but it still cannot magically conjure up new things. And the problem in a debt deflation is that the previous bubble resulted in such a distortion of prices that it resulting in a massive misallocation of capital which is unrecognized and still is to a large extent unrecognized on private balance sheets...

I'm going to have to finish this post later, have more to say but need to go.

[opebo]

Why the hell should we care about 'capital flight'?  If they're unwilling to buy bonds with it, its dead money to us.   We should confiscate it, one way or the other.

[Associate Justice PiT]

Bernake lecturing Congress about "Fiscal Responsibility" is like Bernie Madoff lecturing a shoplifter about the evils of theft,

I hope Congress passes and implements the legislation forcing the fed to open its books.

     Well put. Why am I not surprised by a government official talking about one thing while he does another?

[opebo]

Bernake lecturing Congress about "Fiscal Responsibility" is like Bernie Madoff lecturing a shoplifter about the evils of theft,

I hope Congress passes and implements the legislation forcing the fed to open its books.

     Well put. Why am I not surprised by a government official talking about one thing while he does another?

In all seriousness, transparency at the Fed is not a great idea.  The 'markets' are too panicky to be exposed to what's really going on.