Thursday, July 20, 2006

White Knuckle Time For Bernanke?

Every trader and investor that has been around for a while knows "white knuckle" time. For the uninitiated, white knuckle time comes when the market is against you more than anticipated, margin calls are coming and you have to decide whether you have the resolve to stick with your position or bail. White knuckle time. All the quant models in the world can't help, a combination of judgement and confidence is the hallmark of survivors.

Economists who earn their keep by the value of their opinions have their white knuckle time -- when inflection or turning points are forecast. Such forecasts, built on longer-term economic fundamentals, inevitably come up against a run of data suggesting the contrary. Data lag current conditions, everyone knows that, but sometimes the run is right and the forecast is wrong. Judgment and confidence are tested, stick with the view or do what Keynes did: "When I get new information I change my mind, what do you do?"

Bernanke's forecasts carry a bit more impact. His recent testimony suggests, at least to me, that his white knuckle time may be on the horizon if not already here. At some point, in the face of continued bad inflation news, he will stop tightening with the confidence that the Fed forecast for moderate growth based on weaker housing, high energy costs, and higher interest rates (finally!) will be right. Lack confidence in the outlook and keep tightening, risk recession. If he stops and the forecast is wrong, risk worsening inflation. White knuckle time. There is one thing in their forecast we don't know, where they set the funds rate. Is the next tightening in? Is the model using an endogenous equation for fund? If so, what level is the model coming up with.

Greenspan had his share of white knuckle periods and one fairly analagous to this one was 1995, when he stopped easing before growth turned back up. Then the economy accelerated and market calls for tightening through 1996 were met by a "no change in the funds rate" policy. Greenspan's response to the market was his new paradigm manifesto -- the economy can handle alot more growth without inflation because of technology and globalization. He was right. The market was wrong. How come that paradigm doesn't exist now? Topic for another blog.

Getting back to the current situation, the Fed always had a stated preference to err on the "too tight" side, believing it is easier to reverse downturns than inflation expectations. But Fed Chairmen, especially new ones, are also not immune to public opinion. I doubt Bernanke wants his first major accomplishment to be a recession.

He does, however, have a problem. Greenspan and his global counterparts left a mountain of liquidity that has been moving its inflation impact from financial assets to real ones.

His testimony gave us some Eco 101 -- the lead/lag relationship between interest rates (that is monetary policy) and the economy. He gave us that anecdotal information is more important than published data at turning points and surveys of inflation expectations are critical to read and contain. He didn't give us an explicit roadmap. That isn't necessary, from my vantage point, since the open mouth policy was meant to help the Fed wean the economy off of extraordinary accomodation and onto more realistic levels for the cost of credit. Now, as new FOMC member Mishkin has written, sometimes it is better for the Fed to say less.

In the end, Bernanke gave us a punt. Market reaction, one more tightening, most likely August, and then done. Of course the market did what a punt is supposed to do -- confuse (see Mishkin). On Friday, the market went from certain go to certain no go. A dizzying spin. The coming week suggests more of the same.

What will he do at the August meeting? I think he skips and hangs on with white knuckles, hoping he didn't stop too soon or go too far.

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