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Lawrence G. McDonald

Lawrence G. McDonald

Posted: November 22, 2010 04:53 PM

I kept hearing Thursday from some of my well connected friends on the Street, "Fed Chairman Ben Bernanke is meeting behind closed doors with Senate Banking members today about QE2." I was thinking in my lifetime have we ever seen a more politicized Fed? Have we ever seen a Fed Chairman more publicly challenged by Capitol Hill?

It's clear Bernanke is trying to head off a two-front war. With battle being waged within Federal Open Market Committee FOMC and his new foes in Congress, Bernanke's under friendly and un-friendly fire.

Could Tuesday be Turkey Day for the financial markets? I think there's a good chance we see some serious "dirty laundry" aired which could increase volatility in what normally should be a quiet holiday shortened week.

You see on November 23rd at 2pm, the Fed will release minutes of their Federal Open Market Committee meeting held earlier this month.

Chairman Bernanke and other Fed officials are stepping up their defense of QE2 in the face of growing criticism from several quarters.

While most press attention has been placed on rising Congressional criticism, I think the greater threat to the FOMC's accommodative strategy remains the internal disagreements within the FOMC itself. We could see this up close and personal this week on Tuesday when the minutes are made public.

The team at DC Tripwire tell me that privately, Bernanke has been making the case that QE2 would be equivalent to reducing the Fed funds rate by 75 bps and creating 750,000 - 1 million jobs or 30,000 a month over the planned purchasing period.

Bernanke fears that if policy-makers don't immediately begin to push hard to fix unemployment, the U.S. will face permanent 8-10% unemployment rates and enhanced structural unemployment as in Europe.

Most people understand the inability of other parts of government to address this concern has left the Fed in the awkward role of trying to fix this problem -- again.

Chairman Bernanke delivered a strong defense Friday of the Fed's QE2 strategies in front of an international audience at the European Banking Conference in Frankfurt Germany. In wide-ranging remarks, Bernanke highlighted the importance of rebalancing economic growth between the advanced and emerging market economies--he also raised the issue of appropriate exchange rates.

Bernanke also attempted to reframe the QE2 debate by stating that using the term "quantitative easing" to refer to the Federal Reserve's most recent policy action is inappropriate since the Fed is not seeking to change the quantity of bank reserves and is instead focused on affecting the yields on the acquired securities and, via substitution effects in investors' portfolios, the yields of a wider range of assets. Perhaps because of his growing frustration with Congressional inaction, Bernanke called for a fiscal program that combines near-term measures to enhance growth with strong, confidence-inducing steps to reduce longer-term structural deficits as an important complement to the policies of the Federal Reserve. Bernanke also noted that the possibility of a rise in the U.S. unemployment rate in the near term could not be ruled out.

Restless Natives on Capitol Hill

Chairman Bernanke's remarks come on the heels of increasing criticism of the Fed's actions from political circles. Senator Corker (R-TN) and Rep. Pence (R-IN) head the list of congressional members debating whether to change the Fed's dual mandate of price stability and sustainable full employment. (Note that Bernanke himself has long been an advocate for inflation targeting. Bernanke would no doubt also argue that QE2 is fully consistent with inflation targeting since actual inflation numbers are below where the FOMC wants them to be and are dangerously close to raising deflationary expectations.) Rep. Ron Paul (R-TX), long a proponent of abolishing the Fed, is set to see an increased oversight role in the Republican dominated House, with a likely subcommittee chairmanship in House Financial Services. Sarah Palin has even gotten in on the act, with a recent speech objecting to QE2 and its possible inflationary impact.

What Really Happened Last Week?

So indeed Chairman Bernanke decided to take his case directly to some of his loudest critics by meeting with 11 members of the Senate banking committee this week to discuss plans to inject an additional $600 billion into the banking system. Behind closed doors, Bernanke made the case to these members that QE2 would be equivalent to reducing the Fed funds rate by 75 bps and create 750,000 - 1 million jobs or 30,000 a month over the planned purchasing period. The rationale that Bernanke clearly spelled out was that the Fed fears that if policy-makers do not immediately begin to push hard to fix unemployment, the U.S. will face permanent 8-10% unemployment rates and enhanced structural unemployment as in Europe. According to DC Tripwire there was discussion during this session that the inability of other parts of government to address this area places the Fed in the role of again trying to fix this problem. I think Ben was letting it rip and clearly firing back at members of Congress.

It's clear congressional heat on the Federal Reserve will continue in the weeks and months ahead, particularly if the economy continues to underperform. Withering congressional criticism of the Federal Reserve has been commonplace in recent years, including much scrutiny over Bear Stearns, the assistance granted to AIG, and leaving my former employer Lehman Brothers out to dry.

That heat is not likely to produce substantive change to plans for QE2. Chairman Bernanke has been confirmed as chairman through January 2014, although continued political pressure in some sense will also begin to raise questions about the independence of the central bank. He most definitely is the most powerful unelected man in the history of our Democratic Republic. This is why members of Congress are as nervous as a long tailed cat in a room full of rocking chairs.

While there may be room to critique the Fed's performance and QE2 in particular, markets tend to get even more nervous at the prospect of increased political involvement in Fed affairs. Also, when challenged, the Fed institutionally has proven to rally. Witness the debate leading up to the Dodd-Frank Act, as Senator Dodd and others threatened to strip the Fed of much of its traditional bank supervision role. Ultimately, the Federal Reserve System emerged from financial reform with strengthened authority in several areas.

Economic data released this week also helped Bernanke's argument for QE2. Inflation remained subdued, as the economy experienced the third straight month of flat core inflation. Industrial production was also flat in October.

Friends and Foes

I expect the internal debate at the FOMC to remain spirited and it will still ultimately determine how far QE2 goes. Federal Reserve Bank Presidents and Fed Governors, including the Chairman, have already been in the public eye a great deal since the November 3 announcement of QE2. Vice Chairman Yellen, New York President Dudley and Boston President Rosengren all voiced support for QE2, focusing on the potential for a reduction in the unemployment rate by a little less than half a percentage point by the end of 2012. Minneapolis Fed President Kocherlakota surprised many with his disclosure that he would have voted in support of the FOMC action on November 3.

On the other side, Philadelphia President Plosser, in remarks otherwise focused on the appropriate monetary policy response to asset bubbles, noted that he was not among those who worried that the economy might fall into a deflationary trap, instead expressing that he was more optimistic than many about the economy. Governor Warsh, who did vote for the recent FOMC action, also seemed to express some unease about the plan.

While internal FOMC disagreements could limit the extent of quantitative easing, one potential game-changer related to these asset purchases could be the precarious situation of some state and municipal balance sheets. If the market ultimately refuses to finance states like California, a few policy-makers have begun to wonder whether the Fed would be willing to come to the rescue by purchasing sub-federal government debt. Although we are skeptical of the FOMC's fortitude with respect to QE2, the one thing we have learned with respect to the Fed's accommodative capabilities in a crisis is to never say never.

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