Bernanke Wins! Now, What?

Monday, February 1, 2010

The Senate confirmed Ben Bernanke’s reappointment, albeit with a record high 30 “nay” votes. So, is he now free to act independently? Or does the far-from-unanimous approval vote, combined with the on-going congressional efforts to trim the Federal Reserve’s powers, limit his actions? And what about that negative vote at the Federal Reserve Open Market Committee (FOMC) meeting?

These questions are difficult to answer other than to say the outcome is uncertain. Bernanke certainly exhibited knowledge, independence and perseverance in the difficult days of 2008 and 2009. Now, however, it’s unclear when he will raise rates because doing so will likely provoke congressional ire.

Financial and economic indicators have been improving for almost a year, and the FOMC’s statements have reflected that. Yet, Bernanke and the FOMC have not yet let the Federal Funds rise even a smidgen from their financial-disaster-prevention lows of near-zero. A couple of Federal Reserve bank presidents not on the FOMC have spoken of the need to start letting the rate rise back to its normal level, particularly with the pickup in inflation worries. The one “no” vote on the FOMC last week underscores this concern because there is a strong institutional desire to avoid non-unanimous decisions. We can only guess at how many other members are close to “no” as well.

So, as investors, what do we do? The best approach probably is to prepare for an interest rate increase, realizing it will happen, we just don’t know when. (The next FOMC meeting is March 16, although the group can change rates at any time.) My suggestions for being prepared are:

Be wary of [avoid] bonds. When the Federal Funds rate does climb, it will likely take all rates up with it, meaning bond prices will fall. (In fact, the long-term rates appear to be rising already – see the graph at the end.) In addition, with inflation expected to pick up for a year or two, bonds could experience a trend reversal, with yields rising and prices falling for some time. Those are heavy risks for today’s slim yields.

Okay to own short-term securities and money market funds – anything with a yield that quickly adjusts to short-term rate moves. Yes, the present rates are miniscule, but after a year or two of rising rates, the return for the entire period could look good – especially compared to depreciating bonds.

Good to own US stocks. A common domino theory is that if interest rates increase, the US dollar will rise and hurt exports. Bank’s interest rate spread (meaning the difference between the rate they earn on loans minus the rate paid for deposits) will decline, putting pressure on their finances. Consumer spending will fall (especially for houses and cars), leading to layoffs, etc. etc. Therefore, this would be a bad environment for stocks.

However, domino theories are frequently (always?) wrong because they are overly simplistic. Economics, business management and finances are much more robust than these theories presume. For example:

  • A rising US dollar can foster growth. It gives businesses and consumers increasing financial clout for acquiring goods, services and resources. Also, for the many production and service activities outsourced to offshore locations, costs will drop (in US dollar terms) as the dollar rises.
  • Banks can maintain their interest rate spreads. They are not at the mercy of a short rate rise, so long as there is loan demand. They can charge a rate that is profitable. Also, remember that interest rate spread is only half of the profit equation – the other half is the volume of loans. The improvements flowing through the economy now will spur a burst of lending later. (Lending lags initial economic improvements because bankers necessarily want to get repaid on outstanding loans and gain confidence that the upturn will last.)
  • Consumer purchases can blossom in a rising interest rate environment rather than fall. Remember, we’re talking about rates returning to normal along with the economy. We are not talking about rates rising to cut off excess growth and speculation. Nine trillion in money market funds and time deposits will begin producing income. And can’t you just hear those mortgage brokers and auto dealers telling us to hurry in before rates rise further? It’s been very effective before.

So, here’s hoping Bernanke and the FOMC are able to rise above any political influence and act independently as they see fit – even if it means running counter to Congress’s perpetual desire to keep rates low with easy money. If so, we may see a Federal Funds rate increase by the Ides of March + 1.


I know anyone studying recent history (namely, Alan Greenspan’s 2003/2004 low interest rate period) could conclude that longer-term yields might not rise along with the Federal Funds rate. So, here is a graph showing almost 50 years of Federal Funds rates and 10-year US Treasury bond yields.

Note that every Federal Funds rate rise has been accompanied by long-term rates rising except for Greenspan’s 1.25%-1.00% period. As shown in the graph, long rates increased for over a year before Greenspan allowed short rates to rise. Rather than an example of a typical relationship, it is an indicator of why he is criticized for running an easy money policy too long, thereby creating the environment for the following boom/bust.

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February 2010