Wednesday, February 24, 2010

Is Bernanke Worried About Japanese Deflation?

Federal Reserve Chairman Ben Bernanke said on Wednesday that short-term interest rates would be kept near zero "for an extended period," and said the Fed will "evaluate" whether additional monetary stimulus of some sort is needed:

Unemployment, not inflation, is "the biggest problem we have," he said.

In testimony prepared for the House Financial Services Committee, Bernanke left the door open to further purchases of mortgage backed securities and agency debt beyond March, and in response to questions from committee members, he said the Fed would also be evaluating whether it should extend its financing of new commercial mortgage backed securities past June.

Bernanke, presenting his semi-annual Monetary Policy Report to Congress on behalf of the Federal Open Market Committee, called the Fed's current monetary policy, which includes a 0-0.25% federal funds rate target and $1.1 trillion in bank reserves, "highly accommodative" and "very stimulative."

But when asked whether yet more monetary stimulus is needed to increase economic growth and spur job creation, Bernanke replied, "The FOMC is going to have to continue to evaluate whether additional stimulus would be necessary depending how the economy evolves, so we'll continue to look at that."

He did not elaborate on what form such "additional stimulus" might take. The Fed has no room to lower interest rates further, but it could do more quantitative easing through purchases of Treasury, agency and agency-backed MBS.

That is not the present intention. The Fed ended Treasury purchases last fall and has scheduled the end of agency and agency-backed MBS for the end of March. And Bernanke again described tools the Fed has developed for shrinking or at least absorbing the reserves created through past purchases.

But in his prepared testimony, Bernanke said, "The FOMC will continue to evaluate its purchases of securities in light of the evolving economic outlook and conditions in financial markets."

Later, he said the Fed is "interested to see what the effect will be" of ceasing to buy MBS. "So far it looks like it will be modest."

TALF financing of "legacy" or older CMBS is due to expire on March 31. TALF loans backed by newly issued CMBS is set to expire on June 30. But in response to a question, Bernanke said the Fed will also "evaluate" whether the TALF should expire as scheduled.

He said the TALF has been "successful" in reducing spreads in the CMBS market, but he said the commercial real estate market is still fraught with problems that have broader implications for credit availability.

Commercial real estate (CRE) loans are "the biggest credit issue that we still have." He traced the increase in the number of problem banks to CRE exposure. "There are a lot of troubled commercial real estate properties and they are causing a lot of problems for banks, particularly small- to medium-sized banks and we're watching them very carefully," he said.

To the extent that small and medium-sized regional banks are hurt by CRE-related losses, he said the supply of credit could be further restricted.

Bernanke spoke in his prepared testimony about the Fed's ability to sell securities at some point to shrink its balance sheet and the supply of reserves, but he gave no indication he is eager to do that in response to questions.

On the contrary, Bernanke said the Fed will continue to hold the MBS it has bought and said this will "continue to hold down mortgage rates."

"It is true that we will stop buying new mortgage backed securities at the end of this quarter, but we continue to hold one and a quarter trillion dollars of agency mortgage backed securities, and taking that off the market in itself will keep mortgage rates below what they otherwise would be," he said. "So we believe that there will be stimulus coming from our holdings of those securities as well as our low interest rates."

"So we believe the economy as apposed to the money markets for example still requires support for recovery," he added.

Bernanke reinforced his easy money message by stressing the nation's unemployment problems and downplaying inflation risks.

In the prepared testimony, he said labor markets remain "quite weak" and said inflation "likely will be subdued for some time." In response to questions, he asserted, "unemployment is the biggest problem we have."

In fact, Bernanke did not rule out the possibility that deflation risks could revive. "Right now, we don't see deflation as an imminent risk," he said, adding that "inflation expectations are around 2% or higher." But he added, "there are scenarios in which it (deflation) could become more of a concern."

In addition to its traditional and unconventional monetary easing procedures, Bernanke made clear that the Fed is also using its supervisory powers to "get credit flowing again." He strongly suggested that the Fed is leaning on banks to make more loans.

In its examinations, he said the Fed has been asking banks questions to make sure that "creditworthy borrowers," especially small businesses, are not being denied credit.

Bernanke said the Fed is "working very hard" to make sure small business has adequate credit availability. He said the Fed has "incensed information gathering" to find out "how many loans have been turned down."

"There are some cases where tighter (lending) standards are justified," he said, but he added that the Fed "want(s) to make sure creditworthy (borrowers) are not being turned down ... . We don't want banks to made bad loans ... but where a borrower is creditworthy we want banks to make loans ... . We're working very hard to make sure that is not the case."

As he did in prepared testimony, Bernanke stressed again that the Fed's 25 basis point increase in the discount rate last week does not constitute monetary tightening, nor does it signal it.

"The reason we took action was to reduce the subsidy" to banks borrowing from the discount window, he said, adding, "I do not expect any effect whatsoever" of the discount rate hike on money market rates.

In his prepared testimony, Bernanke said that "by increasing the interest rate on reserves, the Federal Reserve will be able to put significant upward pressure on all short-term interest rates."

In response to questions, he suggested that raising the rate of interest on excess reserves will suffice to put a floor under the federal funds rate. "We think that the interest rate we pay on reserves will bring along with it the federal funds rate within tens of basis points, not a tremendous difference," he said.

His comment would seem to suggest that the Fed will not necessarily abandon the federal funds rate as its main monetary policy instrument or target and replace it with the IOER.

Without the additional tools the Fed has developed -- interest on reserves, large reverse repurchase agreements, a proposed term deposit facility -- Bernanke said that "with so many reserves in the system, we wouldn't be able to raise the federal funds rate.

But with those tools, he said the Fed should be able "to raise interest rates notwithstanding the fact that we have a large balance sheet."

Bernanke said "none of them (the tools) has been completely tested," but he said the Fed has a "belt-and-suspenders" capability. He said "interest on reserves itself could be used to tighten policy" but said the Fed could supplement that tool if necessary by using other tools to drain reserves.

Bernanke acknowledged that raising the interest paid on reserves (now 25 basis points) "would reduce our profitablility a little bit." But he said "since we're making 4% plus on MBS we would still have quite a bit of margin there." The Fed paid the Treasury a record $46.1 billion in 2009 out of net earnings on its operations.

Regarding the possibility of the Fed issuing its own debt -- so-called "Fed bills" -- Bernanke said the Fed is "not proposing that now." He said the Fed does plan to auction term deposits but only to financial institutions that hold reserves at the Fed.

As he has before, Bernanke warned about the long-term unsustainability of federal budget deficits. As currently projected, he said deficits will range between 4% and 7% of GDP even after the economy has recovered. He said it is "very important that we look at the trajectory" of deficits and reduce them as a percent of GDP.

Bernanke said deficits affect market interest rates not just in the future but "today." He warned that if bond markets lose confidence in U.S. fiscal policy long-term rates could rise in a counterproductive way. So he said "it would be helpful if there were a credible plan for fiscal exit."

A loss of confidence in longer term fiscal policy would push up long rates and be "a drag on the economy, he warned.

What's more, if confidence is lost, "the dollar could decline, which would have potential inflationary impact," he added.

Chairman Bernanke is right to worry about deflation. He's looking over at what's going on in Japan where Bank of Japan Deputy Governor Hirohide Yamaguchi earlier on Wednesday said the BOJ is ready to act to act as deflation weighs:

Yamaguchi, a career central banker seen as close to BOJ Governor Masaaki Shirakawa, said the BOJ's key task was to boost demand and show its determination to beat deflation so that the public doesn't take the view that price declines will persist and then hold off on spending.

"To overcome deflation, patient treatment of its root cause, which is a lack of demand, is necessary," Yamaguchi said in a speech to business leaders in Kagoshima, southern Japan, on Wednesday.

"It's important to make sure corporate sentiment doesn't shrink, so that deflation doesn't trigger economic weakness and further aggravate deflation."

The government, hobbled by a huge fiscal debt, has been pressuring the BOJ to support the fragile economy even as most other major central banks mull rolling back stimulus steps put in place during the global crisis.

The central bank has said it is committed to fighting deflation but it hasn't said how it will go about it.

Many analysts say it could pump more money into the banking system or offer cheap longer-term funds to bring down longer-dated interest rates such as six-month rates, particularly if the yen rises further and threatens to deepen deflation.

"The BOJ can't escape the fact that prices are still declining," said David Cohen, director of Asian economic forecasting at Action Economics in Singapore.

"The BOJ would be happy to stay on hold indefinitely, but they could do something to lower short-term rates to appease the government. Price declines will narrow as long as the global economy continues to recover. But a decline is a decline."

The core consumer price index likely fell 1.4 percent in January from the previous year, with annual price falls accelerating for the first time since they slumped by a record in August, according to a Reuters poll. The CPI data is due out on Friday.

The Japanese yield curve has steepened as expectations the BOJ could ease monetary policy further has kept shorter-dated yields low, while longer-dated maturities suffer from concern about Japan's fiscal condition.

Yamaguchi said recent economic developments have not changed much the public's long-term price expectations.

But he said the BOJ needs to ensure that price expectations remain stable and don't swing towards the view that deflation will last for a very long time.

Deflation hurts the economy as households put off spending on hopes that prices will fall further, forcing companies to cut prices to lure consumers.

One person who believes that deflation is coming in the US is Bob Prechter who says that the extraordinary action taken by the Federal Reserve to bail out the economy will not lead to runaway inflation.

"Deflation is gaining the upper hand very, very slowly, but it's happening," Prechter the founder of Elliott Wave International tells Tech Ticker. Of course, as anyone familiar with his work knows, he's been saying this for years.

Why should we believe him now?

For the first time since 1982 core inflation fell in January as measured by the consumer price index. Prechter says it's even more noteworthy that it's happening "in the face of this tremendous amount of stimulus...from the government and a real attempt at stimulus from the central bank."

Prechter describes the forces of deflation as a "socio-nomic" shift in social mood that will prevent Federal Reserve Chairman from printing too much money. "At some point, the voters - as you can already see from the Tea Parties - are going to start saying we've had enough" with government spending and bailouts.

How should you invest in a deflationary environment? Mr. Prechter believes nobody should be taking risk right now and thinks the bond market is the "biggest bubble in the history of the world":

"What has happened is a complete change in psychology from extreme negativity [a year ago] to extreme optimism" heading into the market's recent top in January, Prechter says.

Among the many sentiment indicators he watched, Prechter cited the very low levels of cash at mutual funds, which is approaching levels seen near major tops in 1973, 2000 and 2007.

"Nobody should be taking risk right now. This is a time to be safe," he says.

But considering U.S. equity funds suffered about $46 billion of outflows from August to December 2009 while bond funds took in about $198 billion, according to ICI, aren't investors already playing it safe -- a bullish contrarian signal?

"The individual investor has been more or less abandoning stocks" and buying bond funds, Prechter concedes. "I think that is going from the frying pan into the fire. The bond market is the biggest bubble in the history of the world. "

Corporate debt, municipal debt, mortgages and consumer loans will all suffer in the great deflation Prechter believes is already underway, as detailed in his book Conquer the Crash.

So is there any way for investors to protect themselves from the carnage? Mr. Prechter thinks in a deflationary environment, cash is king. If his predictions come true, many investors, including those that are overweight gold, will get creamed.

As you listen to the interview below, keep in mind that many pension funds investing trillions in risk assets will also get creamed if deflation sets in. Bernanke knows this, which is why he's not prepared to raise rates before he sees solid gains in employment and a pick-up in inflation expectations.

**UPDATE: Why Prechter is Wrong on Deflation***

On Thursday, renewed concerns about Greece's credit rating and the future of the EU gave the dollar a boost, with commodities and equities suffering as a result. Broadly speaking, the market action seems to justify Prechter's warning.

Not so fast, says Peter Boockvar, equity strategist at Miller Tabak, who believes inflation remains a bigger long-term threat to the market and U.S. economy.

"It's the reaction to the potential deflation that gets to the inflation," Boockvar says. "The more deflationary type steps we see, the more money printing that will go on around the world that will set us up for that inflation. More deflation will eventually get us more inflation."

It may seem somewhat convoluted logic, but Boockvar's point is that global policymakers will do anything and everything to fight deflation, most definitely including Fed chairman Ben Bernanke.

See Peter Bookvar's interview by clicking here.

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