February 1, 2007

The Bernanke Era - One Year In

One year ago today, in a low-key ceremony in the Federal Reserve Building in Washington D.C., Ben Bernanke was sworn in as Chairman of the Board of Governors of the Federal Reserve System.

He followed in the footsteps of long-time Fed chairman Alan Greenspan, who stepped down after 18 years at the helm, leaving behind what many considered to be a troubled economy.

Following the bursting of the stock market bubble in 2000, interest rates had been dropped to multi-generational lows while mortgage lenders and Wall Street firms were given free rein to "get creative". What ensued was a real estate bubble of epic proportions where home prices became far detached from traditional valuation measures such as rents and income.

The economy once again boomed and interest rates were gradually raised starting in 2004, but the long sequence of "baby steps" had not yet come to a conclusion as the Greenspan era came to an end.

Signs of distress in the housing market were abundant one year ago. Sales volume had begun to decline and inventories were building.

Notably, The Economist magazine portrayed the Greenspan to Bernanke transition as two runners in a relay race, one runner handing a stick of dynamite labeled "Economy" to the other as the fuse burned brightly. Such was the concern that a faltering U.S. housing market in early 2006 might undo the economy.

The Pause that Refreshed

While many urged him to suspend the interest rate raising cycle, the new Fed Chief went on to raise short-term interest rates three more times in 2006 - in March, May, and June - before finally leaving rates unchanged in August. Many pondered the fate of both the housing market and the stock market following the "pause".

Precedent seemed to suggest that equities were more likely to fare poorly after a series of interest rate hikes. The Dow Jones Industrial Average went on to make new all-time highs as 2006 drew to a close.

Some feared that short-term interest rates had already been raised too high to support the continued use of popular adjustable rate mortgages. While housing showed increasing signs of strain, subprime lenders began to fail at an alarming rate and builders slashed both payrolls and home prices as sales volume continued to decline.

In many once-hot areas, home prices declined 10 percent or more and pundits feared a slowdown in consumer spending - the life-blood of the American economy.

Despite a few weak retail sales reports and slowing third quarter GDP growth, consumer spending was resilient. Yesterday, the first look at fourth quarter GDP showed a healthy 3.5 percent annualized rate of growth.

The labor market has remained steady. Though many disparage the quality of the jobs being created, few contest the quantity (though massive revisions by the Bureau of Labor Statistics make the data increasingly difficult to interpret).

And after a summer of rising consumer prices, with headline inflation at four percent and the core rate of inflation (excluding food and energy) close to three percent, energy prices fell dramatically. The summer hurricane season had been a flop, the winter started out unusually warm, and both hedge funds and investors began to look elsewhere after the bloom came off of the commodity boom.

One year in, Ben Bernanke has seen inflation quelled, labor markets steadied, and growth rebound in spite of a housing market that now shows "tentative signs" of recovery. More importantly, equity markets are again soaring.

Overall, it's been a very good year for Mr. Bernanke - based on a review of nearly any economic measure, few would complain about the job that he's done.

Aside from a housing market slowdown that may last much longer than he thinks and an increasingly likely fat tail financial event that should be causing him a few restless nights, there appear to be just two nagging problems with the Bernanke era after one year.

Making Ends Meet

First, while expressing concern on a number of occasions about wage inequality - the extent to which the recent prosperity has not benefited the working class - the new Fed chairman appears to be turning a blind eye to the plight of the fixed income crowd.

He is apparently unaware that seniors and others who are dependent upon cost of living increases are slowly being squeezed by the rising cost of life's essentials - utilities, food, and medical care. These individuals have not benefited from low prices for imported goods from Asia, one of the keys to the current era of reportedly low inflation.

His recent commentary before the Senate Banking Committee when sanctioning the use of an alternate inflation gauge to reduce the long-term cost of entitlements showed a lack of understanding of what faces many retirees these days.

Social security is not his problem to fix and by offering aid in this manner, he appears to be bending to political will already. Surely he can't believe that for retirees, "true" inflation is a full percentage point lower than the official figure from the Bureau of Labor Statistics, currently at 2.5 percent.

A Democratically controlled Congress may begin to question what "true" inflation really is.

The Barbarous Relic

The second nagging problem during the new Fed chairman's first year is the price of gold. While the Bernanke era officially began exactly one year ago, many would argue that it began when his nomination arrived in the Senate in October of 2005, just after Hurricanes Katrina and Rita hit the Gulf Coast.

Since that time, in less than a year and a half, the price of gold has risen 40 percent.

While annual gains of 20 percent or more were seen in 2002 and 2003, very few people noticed or cared. Fast forward to 2005 and 2006, and central banks around the world are talking about buying gold rather than selling it and Wall Street firms continue to come up with more ways to make it easier for retail investors to buy the metal.

A rapidly rising gold price that appears ready to head even higher (maybe very soon) should give most any central banker reason to worry.

What does it say about the stewardship of the government's money if nature's money outpaces its returns by a wide margin year after year?

The May 2006 event can be written off as a bout of speculative fever - an anomaly - but if new highs are made this year along with a third consecutive 20+ percent annual increase in price, what does that really say about the job being done at the Federal Reserve?

By standard economic measures, it's hard to find fault with Ben Bernanke's first year.

When looking elsewhere, the story is a bit different.