Disastrous Fed Policy
September 25, 2012
Bianco cited a number of statements by Fed Chairman Bernanke showing that the Fed intends to target 2% inflation, based on the personal consumption expenditure (PCE) index. Bianco noted, though, that the basis for that target, according to Bernanke, is that it represents a consensus of other central banks.
Paul Krugman, who Bianco called the most influential economist in the US, has called for a higher inflation target. Bernanke’s response was that would impair the Fed’s credibility, which has been earned by maintaining low and stable inflation for the last 30 years.
For economists, the relevant question is if inflation will deviate from 2% and, if it does, what response the Fed will adopt, according to Bianco.
Although inflation is currently near that target, expectations are for higher inflation. The 10-year Treasury-TIPS breakeven rate was a 2.64% the Friday before Bianco spoke, which is the highest that measure has been in the last decade, according to Bianco. Another measure is the five-year, five-year forward rate, which measures inflation expectations over a five-year period, five years from now. This figure has spiked to nearly 3%, as high as it has been in several years.
“The market is telling us when you are going to get well in excess of 3%,” Bianco said.
Another inflation-forecasting measure is the Philadelphia Federal Reserve survey of economists, but Bianco said that survey has not been updated since the Fed announced its latest round of quantitative easing.
During the question-and-answer period, Bianco was asked how inflation could occur in a weak economy – characterized by high unemployment, falling median income and an output gap in production. He said it would be “cost-push” inflation, because quantitative easing would drive up the price of commodities, such as oil, which – together with food – represent nearly a quarter of the CPI.
In addition, escalating rental rates – driven by fears of home ownership – would drive up the housing component of the inflation measure. Bianco said housing represents over 20% of the CPI.
The US can have rising inflation and high unemployment, as it did in the 1980s when both measures were at or near double-digits, Bianco said.
Disastrous quantitative easing
Bianco said he is part of the consensus, when it comes to the Fed’s recently announced policy of ongoing quantitative easing: It will matter for the market, but it will do nothing for the economy.
“The Fed is boldly moving forward with a failed policy, and everybody is happy about it,” he said.
But the Fed’s policy is predicated on a wealth effect, and Bianco doesn’t believe the desired result will ensue.
By buying bonds, the Fed will depress interest rates, incenting investors to buy other fixed-income securities. As rates on those bonds are pushed down, investors will move into successively riskier assets, from corporate bonds to high-yield bonds to high-quality stocks to low-quality stocks. Indeed, investors could buy futures on crude oil, which would produce the cost-push inflation Bianco predicted.
Bernanke has also said consumers’ confidence will grow and with that consumption. But, Bianco said, “that is absolutely not happening.”
In order for consumer confidence to rise, Bianco said, two things must occur. First, wealth – particularly in the stock market – must surpass its previous peak. But the S&P peaked at 1,560 in October of 2007, and it is still below that level.
Moreover, that growth must be viewed as permanent. That’s why the housing boom had a wealth effect; consumers perceived it as permanent growth. But consumers do not perceive the current increase in equity prices as permanent, Bianco argued, citing the fact that money has been flowing out of equity mutual funds over the last several years.
Bianco said the Fed is effectively betting that wealth in the stock market will “trickle down” into the real economy. “That is why I think it is ultimately going to be a disastrous policy,” he said.
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