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Hangin' with the Fed


Ross M. Miller
Miller Risk Advisors
May 22, 2006

While watching Ben Bernanke from a safe distance to decide whether or not I would approach him and introduce myself, he reminded me of someone, I just didn't know who. We were both standing in a courtyard at the newly reconstructed main building of The Cloister on Sea Island. I was there at a Fed conference on hedge funds and had no one with me; he was there to give the keynote address and had four Fed governors and a minimum of four Secret Service agents with him. In conformance with The Cloister dress code, I was wearing a Brooks Brothers navy blue blazer and my favorite Hermès tie. Ben was wearing a well-tailored dark suit and tie of unknown origin. (Any attempt to look at the labels would likely have revealed the exact number of Secret Service agents in attendance.)

Figuring that I would live to regret pass up shaking hands with arguably the most powerful man in the world, I went over and introduced myself as my professorial self, as opposed to my alternative personae as globetrotting consultant, best-selling author, hard-hitting journalist, and all-around cad. We shook hands. (Unlike some I know in positions of power, he did not Purellify himself afterwards.) I mentioned that we had gone to different grad schools together—I was at Harvard at exactly the same time that he was at MIT. He asked if I knew Larry Summers. I said something vaguely complimentary about Larry. That was it. Ben is not a very good conversationalist and lacks the charm, if we can call it that, of his predecessor.

On later reflection, I figured out who Ben Bernanke had reminded me of—an undertaker.

I could have offered Ben sage advice about how to do his job, but I had already spent the first thirty years of my life learning not to do things like that. Anyway, that is why the Web was invented.

The current thread of my commentaries dates back just over two years to one entitled "The Bull That Will Not Die." In that commentary, I argued that I thought that Alan Greenspan would fail to act quickly enough to raise interest rates, so inflationary pressures would prop up the stock market for far longer than was commonly expected. (At the time, it was generally believed that the stock market would collapse soon after the 2004 presidential election.) I was off on some of the details—tech stocks did all right over the past two years, though not as well as I had hoped—but the picture of the economy I painted turned was better than one would expect from someone with a Ph.D. in economics.

I do not think that the Fed realizes the full extent of the inflationary challenge that they face. (It should be noted that I am among an apparent minority who think that inflation is not currently—to use Bill Gross's word—benign.) The place that they should want to be is a world with at most a 4% fed funds rate and a negligible inflation rate—the equivalent of 1% to 2% under the old, pre-Boskin bookkeeping system. The way that they are going, they might never get there. (It is worrisome to read that Thomas Hoenig, president of the Kansas City Fed, is fine with 1½% to 2½% core inflation as currently measured. The high end of that range could easily translate to what would have been 7% overall inflation in days of old.) The Fed may have a big pile of statistics, but there is nothing that I observed in three days of hanging with them that indicates that they know the first thing about human behavior, especially in the context of expectations formation. (If the Fed hires behavioralists in senior research positions, they do a good job of hiding them.)

The Federal Reserve should want its actions to have a meaningful impact; otherwise, why do anything in the first place? The past two years of telegraphed, "measured" increases in the fed funds rate has gotten the rate from 1% to 5% with the minimal of pain, except in the form of higher prices. Inserting "pauses" into process, as the Fed is currently telegraphing to us, will mute their impact even further.

The Fed must eventually give the appearance of taking decisive action. At the current 5% fed funds rate, baby steps of 25 b.p. seem pointless. They should immediately revert to 50 b.p. moves until either the rate dips back below 4% or things are sufficiently stable that fine tuning is in order. (Don't hold your breath.)

Barring some really fine May numbers or one of the global dislocations that tends to greet new Fed chairmen, Bernanke and company should raise the fed funds rate by 50 b.p. to 5½% at their end-of-June meeting. Then, they should abandon all of the text from the previous statements and draft a new statement from scratch. The Fed should indicate that it is no longer on a fixed schedule of rate increases in terms of their magnitude, direction, or timing. Other than that, the less they say; the less that the market has to misinterpret. (Has anyone figured out what "yet" means yet?) The core message should be that the old regime is history.

The problem that the Fed faces if it continues on its wimpy course is that it will have to raise rates well above 5½% to convince the market that it is not about to fire up the helicopters and the printing presses. The more that it pauses (or even mentions pausing) the higher it will ultimately have to go.

The main reason that I wanted to get up close and personal with Ben Bernanke was to be able to take stock of him in a way that is only possible through direct observation. My take on Ben is that he is one smart and serious fellow, dead serious. I do not doubt for a moment that he understands that if he lets inflation get away from him now, he will spend what remains his time at the Fed chasing it. If Ben overshoots and causes a recession, which is likely, he can say that we were overdue for one and that it was oil's fault anyway.

In case you were wondering about the Fed and hedge funds, that commentary is coming in four weeks, roughly concurrent with its appearance in Financial Engineering News. Although it is difficult to tell from all the rain and cold up here in the northeastern U.S., summer is almost here. Now that I am an academic (for at least one more year), summer time is research time. To balance things out for me, these commentaries will become if not entirely frivolous, highly self-indulgent. About the most self-indulgent thing that I can do is to look at these commentaries themselves, which I will do as part of "The Public Side of Self" next time.

Copyright 2006 by Miller Risk Advisors. Permission granted to forward by electronic means and to excerpt or broadcast 250 words or less provided a citation is made to