Bernanke Admits He Just Does Not Know
Early on in his June 22, 2011, press conference, Federal Reserve Chairman Ben Bernanke was asked about why the Fed had just lowered its growth outlook for 2011 and 2012. After attributing some of the reduction in expected economic growth to temporary factors that he feels should be self-clearing, he finally admitted that:
"We don't have a precise read on why this slower pace of growth is persisting. One way to think about it is that maybe some of the headwinds that have been concerning us, like, you know, weakness in the financial sector, problems in the housing sector, balance sheet and de-leveraging issues -- some of these headwinds may be stronger and more persistent than we thought."
The Federal Reserve Chairman finally admitted reality, if only fleetingly. The Fed still believes that the economy will achieve both its long-run "central tendency" growth rate and its long-run "central tendency" unemployment rate. He just does not know how.
If he is continually surprised by the stubbornness of headwinds, shouldn't the next logical question be why should we just take him at his word about 2012 and beyond? The economy is clearly not performing up to his model's calculations, not responding to his "temporary" monetary medicine, so why will it suddenly do so now?
Eight consecutive quarters of a zero interest rate policy (ZIRP) was once thought to be the unbreakable boundary of monetary possibilities. Two and a half years later, we still have the Fed's "extended period" language to "comfort" markets. Taking them at their word today means that we will likely see nearly five full years of ZIRP by the time we finally get to its currently predicted end. At what point is temporary just a buzzword?
Every single pronouncement and baseline that fiscal and monetary policy has been created to achieve shares the same unspoken source. Growth just happens because it always happens. The fact that the Fed uses the term "central tendency" tells you all you need to know about what the Fed knows about economic growth. A recovery is assumed to be a cyclical reversion in response to each and every contraction.
Recoveries used to be automatic cyclical responses, but something has altered the "central tendency" of economic healing. The past three recoveries (present one included) have been much weaker and have taken much longer than previous versions. Instead of recognizing the role "temporary" measures are likely playing in this change (low rates tax savers and distort price signals), mainstream economic belief remains unchanged in its recognition of, and focus on, economic "slack".
If unemployment is high and inflation (the Fed's narrow definition) is low, then the economy has to be far below its potential. A large output gap, as it is technically known, cannot remain for long. Mainstream economics is premised by the principle that the economy will always move to its equilibrium potential. If you happen to believe that the inflation/employment relationship actually defines true potential than you might follow Mr. Bernanke on his quixotic quest.
Modern economic thought about chaotic systems and achievable equilibriums is beyond problematic. How do we know what economic potential really is? Are we really supposed to believe it is as simple as an employment/inflation tradeoff?
These are not neutral or academic questions. Monetary and fiscal measures have obvious, harmful side effects (such as the debt ceiling drama). Rather than obsess over whether headwinds are temporary, it might be more worthwhile to make sure that harmful policies are really needed to bridge a gap that may not even exist.
This is a topic I have discussed at length, most recently here. Instead of relying on the antiquated notion of employment-driven inflation, perhaps we can get to the heart of the matter more quickly and directly by focusing on the dollar and its relation to other currencies.
Currencies offer a much purer link to the economy since forex markets are nearly impossible to manipulate and are truer reflections of the economic systems that underlie them. The number and dispersal of transactions that determine long run currency movements is likely a far better gauge of economic potential than Mr. Bernanke's models. After all, these transactions, in contrast to the Fed's academic exercises, have the explicit risk of principal loss.
The starting place for currency crosses is inflationary expectations and interest rate differentials. These are important in how they directly link the relationship of both monetary and economic growth to other financial systems. Since interest rates, freely determined rates anyway, are expressions of both risk and reward, they are intimately connected to the growth potential of an economy. Currency crosses, then, are likely a more valid and useful estimation and expression of long-term potential.
If we look at the U.S. dollar in relation to the euro, the Swiss franc and the Australian dollar, a remarkably consistent pattern emerges. Except for a few short-term deviations (such as the panic of 2008), the Australian dollar and Swiss franc have moved in near lockstep against the U.S. dollar.
This is revealing because the Swiss economy is far different than the Australian economy (much more resource dependent). The fact that the currency expressions of these two very diverse economies are nearly synchronized is highly suggestive that movements in all three currencies are driven solely by U.S. dollar factors.
When we add in the euro, it also closely follows the franc (an almost perfect correlation) and Aussie dollar in the pre-crisis period. In the post-crisis period after early 2009, the euro has seen more volatility, but in general it has not resumed its gains against the U.S. dollar.
Since November 2000, the Swiss Franc has gained 114% against the U.S. dollar. The euro reached its nadir that same month and has gained 70%. The Australian dollar turned decisively in September 2001, moving 122% against its American counterpart. These are massive movements, though they are spaced out over eleven years. The timing of the moves is not coincidence, in my opinion, as they represent an inflection in how the world's view of the U.S. economy has evolved.
Coming out of the 1990's, the U.S. was an undisputed powerhouse. It was a dynamic incubator of revolutionary innovation, so powerful it was thought by some to have relegated the business cycle to the ashbin of history. Despite all the hype, the economy has never fulfilled these overdone expectations. The burst in the optimistic bubble as the dot-com crash gained growing acceptance forced a wider re-evaluation of those expectations. The U.S. dollar's inflection was an overt acknowledgement that economic potential was well below previous estimates.
This process of reduced expectations of potential was reinforced by the recovery that followed the 2001 recession, as it was mired in weakness until 2003 - almost two years beyond where the output gap calculation believed the recovery to be. The fact that it failed to match the historical, cyclical pattern also confounded the Fed, and as a result former Fed Chairman Greenspan was "forced" to keep interest rates low and liquidity plentiful until the "output gap" was finally closed by the massive housing bubble (hardly a true expression of true potential).
The weakening dollar during the recovery period was really a confirmation that the output gap never really existed, and that true economic potential was likely much lower than thought. Had the Fed's calculation of potential been valid, no housing bubble would have been necessary to meet it.
There was a temporary reprieve in the dollar's depreciation during the mid-decade expansion since it appeared to conform to central tendencies. From the beginning of 2004 until October 2006, the U.S. dollar held steady against the three currencies.
Again, the timing of the next leg down for the U.S. dollar is not coincidence, matching the top and first leg down of the housing collapse. From late 2006 on, the U.S. economy operated under the strain of financial and economic stress, with the dollar matching the stress by reverting to its weakening trend. The economic "success" of the 2003-2007 period was unmasked as artificial, and the currencies recognized it as such.
The only recent interruption to that weakening pattern was the panic of 2008 itself. But the dollar "strength" seen at the height of the crisis was related to the dollar shortage created by the collapse in eurodollar interbank collateral far more than any expression of relative economic vigor. Banks that had massive short-term dollar exposures through eurodollar funding were forced into a desperate search for dollar-denominated cash or collateral once their dollar-denominated mortgage bonds were shunned. Had the eurodollar market been denominated in euros or some other liquid currency, there would have been no flight to the dollar.
The temporary reversal in the longer-term trend was entirely a function of interbank operations. Once the panic passed, the dollar resumed its now decade long slide against the franc and Aussie dollar. Against the euro, there has been much less movement due to the continent's own economic questions.
If we view these currency movements as a proxy for economic potential, then the lack of organic growth during the past eleven years becomes much clearer. Rather than conform to some idealized "central tendency", the dollar is being re-adjusted for a different kind of economic reality: a profound disappointment in the face of last century's high hopes.
The consequences for such a dramatic reset will be felt for years, perhaps decades. To regain the lost ground in the global competition for scarce resources within a globally integrated economic system will require either a sustained period of high organic growth, or, more likely, a more permanent revaluation of the terms of international trade and financial flows; i.e., price inflation for U.S. businesses and consumers. In other words, the dollar's constituents are becoming poorer within the global system and this currency-based poverty is the surprisingly stubborn headwinds.
The fact that the dollar continues to slide even after having been more than cut in half over the past eleven years says far more about the world's estimate of economic potential than any academic assessment of an output gap. The boost to growth that the 1990's dollar gave the economy going into the 2000's, coupled with monetary over-expansion, masked this hard truth.
The depreciating dollar and its inflationary impacts, should they ever be incorporated into the Fed's models (a low probability to be sure), would show Chairman Bernanke that the output gap is not nearly as large as he believes, and possibly does not exist at all. At this point it would be very useful to re-evaluate whether it makes sense to implement measures that form a monetary bridge to nowhere.
Using this knowledge as a basis for action, he could then reverse all the temporary policies before they become permanent corruptions to the normal course of economic and financial business. At the very least, he would not be so surprised by persistent weakness.