Bernanke's Testimony at the House

by Calyon Fixed Income Research

The key take-away points for market participants from Mr. Bernanke's testimony today were:
1) The Fed expects to keep the Fed funds rate low for longer than many had thought. This led to a decline in rate expectations priced in Fed funds futures contracts and a rally in the bond market.
2) The Fed had the tools to reduce or neutralize the impact of the increase in bank reserves, when it becomes appropriate to do so, to prevent the emergence of inflation pressures.

Monetary Policy

The Chairman's prepared remarks on monetary policy were clear. “In light of the substantial economic slack and limited inflation pressures, monetary policy remains focused on fostering economic recovery.
Accordingly, as I mentioned earlier, the FOMC believes that a highly accommodative stance of monetary policy will be appropriate for an extended period.”

Prior to his testimony at the House today, Mr. Bernanke penned an article, published by the Wall Street Journal,
detailing the Fed's exit strategy from its current highly-accommodative monetary policy stance. The Fed has rapidly expanded its balance sheet through the purchase of longer-term securities and through lending programs targeting key sectors of the credit markets. While noting that accommodative policies will likely be needed for an extended period, the thrust of the article was that the Fed had the tools to reduce or neutralize the impact of the increase in reserves, when it becomes appropriate to do so, to prevent the emergence of inflation pressures.

Timing of Exit Strategy

When queried further on the timing of the exit issue, the Fed Chairman indicated that the FOMC would be looking for evidence that a sustained recovery will begin to close the output gap and improving labor market conditions. In addition, inflation expectations would be monitored closely.

Since monetary policy works with a lag, the FOMC will have to base its decision on economic and financial market projections.
The current FOMC outlook, as published with the June minutes, looks for a sluggish recovery in 2010. “Participants generally expected that household financial positions would improve only gradually and that strains in credit markets and in the banking system would ebb slowly; hence, the pace of recovery would continue to be damped in 2010. But they anticipated that the upturn would strengthen in late 2010 and in 2011 to a pace exceeding the growth rate of potential GDP.”
This suggests that the FOMC policymakers do not expect to see the output gap begin to close until late next year and into 2011. That would be the time for the FOMC to begin considering rate hikes. It would be consistent with the “extended period” of low Fed funds and with the view of most FOMC participants that inflation will “remain subdued over the next two years.” We maintain our view that the Fed is likely to keep policy unchanged through 2010.

Fiscal Balance

Mr. Bernanke opined that trillion dollar deficits as far as the eye can see were not sustainable. While he did not think that there was “much that can be done about this year's deficit and probably not too much about next year's deficit”, he urged Congress to develop a broad credible plan for spending and taxation that would bring the deficit down (to about 2%-3% of GDP) over time. This would reduce government financing needs and support economic growth by keeping interest rates low. He was quite clear that the Fed will not monetize the Federal government's debt. He was noncommittal on the need for additional fiscal stimulus.

Real Estate

Several Congressmen voiced concerns over stress in the commercial real estate markets, given financing difficulties. The Chairman noted that the Fed had just begun to accept CMBS in the TALF program and that more time might be needed to see improvement. The Fed believes that the foreclosure rate is likely to peak in the second half of 2009, corresponding to a projected peak in unemployment, with somewhat less (but still a high level of) foreclosures in 2010.

In a related question on dealing with asset bubbles, such as was experienced in housing, the Chairman stated that the problem may be able to be addressed as part of the reforms dealing with systemic risk. “When you have an asset whose price is rising quickly, you could require greater capital against it, for example, or greater downpayments.” This contrasts with prior views that the Fed was not able to identify bubbles, as such, and should use monetary policy to deal with the aftermath.

Crisis Response

Mr. Bernanke highlighted the role the Fed played in responding to the crisis and its innovative credit easing response. There was much discussion on controlling systemic risk. A way to resolve institutions that were “too big to fail” was deemed crucial. Bernanke stated that he believed that the government would see nearly all of the capital it gave to healthy banks under the Capital Purchase Program returned but the cost of the AIG bailout would depend on “ how markets evolve and how the firm does going forward”.

Tomorrow, Mr. Bernanke will have another Q&A at the Senate.

Mike Carey
Chief Economist - North America