Bernanke in a Box
Tuesday, June 9, 2009
The market is showing its growing unease about the Obama budget.
One has to pity Ben Bernanke as he tries to attain the Federal Reserve’s dual mandate of promoting economic growth while maintaining price stability. For the currency and bond markets are increasingly focusing on the long-run inflationary impact of the Obama administration’s budget, which according to the Congressional Budget Office will double the U.S. public debt-to-GDP ratio from 41 percent in 2008 to 82 percent by 2019. And the markets are also focusing on the Federal Reserve’s newly announced policy of “quantitative easing,” which they fear could be tantamount to monetizing the administration’s ballooning deficit.
The market’s growing unease about the Obama budget is most plain to see in the renewed collapse of the dollar to its lowest value this year. The dollar’s collapse in turn is now fueling a strong rally in international commodity prices in general and in the price of oil in particular, which has to raise longer-run inflationary concerns in the United States.
Of equal concern for Fed chairman Bernanke has to be the fact that foreigners appear to be bailing out of their long-dated U.S. Treasury bonds. As a result, ten-year U.S. Treasury yields have increased by around a full percentage point over the past two months to their present level of 3 ¾ percentage points. This spike in U.S. Treasury yields is causing parallel increases in mortgage rates and in other private sector borrowing rates, which are priced off U.S. Treasuries. And these interest rate increases now threaten to delay any stabilization in the economy in general and in the housing market in particular.
The currency and bond markets are increasingly focusing on the long-run inflationary impact of the Obama administration’s budget, which according to the CBO will double the U.S. public debt-to-GDP ratio from 41 percent in 2008 to 82 percent by 2019.
In March 2009, after having cut the Fed’s short-term policy rate to 0–0.25 percent, Bernanke indicated in broad terms that the Fed would aim to reduce long-term interest rates by buying up to US$1250 billion in mortgage backed securities and US$300 billion in U.S. Treasury bonds. Bernanke is now faced with very delicate task of providing the market with greater definition as to how “quantitative easing” is to be exercised in practice.
If Bernanke intimates that the Fed will be cautious in the way it will intervene in the long-dated bond markets, he could find that long-dated interest rates will remain at a level higher than might be desirable for promoting economic recovery. If, instead, he intimates that the Fed will be more aggressive in its purchases of long-dated bonds he could find that he will only fuel fears that the Fed will monetize the government’s outsized deficits. Such a course runs the very real risk of heightening concern about the dollar and of further raising long-term interest rates as inflation fears are fueled.
One has to hope that the Fed opts for a cautious approach to quantitative easing for fear of a real dollar collapse and a bond market buyers’ boycott. However, what one really must hope for is more responsible budget policy from the Obama administration, which is after all the root cause of Bernanke’s present impossible task.
Desmond Lachman is a resident fellow at the American Enterprise Institute. He was managing director and chief emerging market economic strategist at Salomon Smith Barney and a deputy director in the International Monetary Fund’s policy and review department.
FURTHER READING: Lachman wrote “Can the IMF Really Save the World Economy?” and “The World Economy’s Europe Problem.” His article “Don’t Repeat Japan’s Mistakes” warns against the policies Japanese authorities followed during their financial crisis in the early 1990s.
Image by Darren Wamboldt/Bergman Group and Flickr user ShinyThings.