Bernanke's Legacy Problem




The surprise of the week was not the goofy ending to the cliff. It was the minutes from the Fed.


The meeting in question took place on 12/12, just 23 days ago. Some very major announcements came as a result of that meeting. A new, and much more aggressive Fed policy was revealed. For the first time ever, the Fed set a target for when monetary policy would change.


The Fed said it would keep its foot on the monetary gas pedal until unemployment fell to 6.5%, and maybe even lower than that. The economic forecasts that the Fed released showed a consensus estimate for unemployment staying above the magic 6.5% until at least 2015. So that set a bar for any changes in monetary policy years into the future.


The Fed backed up its new long-term commitment to boost the economy by doubling up with QE4 – another $45b a month of POMO buys. In December the Fed set the “needle” for monetary steam at the same level that existed during the dark days of 2009. All in, the last Fed meeting was a precedent setting commitment to extended monetary easing. At least that is how I read it.


And then we get the minutes from the meeting where all these dramatic steps were taken. The minutes read completely different. What the hell happened? I have the sense that there was a conversation that might have gone like this:



Okay, we will go forward with QE4. This is our last chance to do anything for a long time to come. There will be no more QE on my watch as head of the Fed.



But, but Ben…..We just promised…..



You’re kidding? I love it! But I don’t understand. What’s up?



I’m looking at the calendar. I’m outta here it 18 months. Before I leave, and turn the keys over to the next guy, I have to “regularize” monetary policy. So that means we end the LSAP’s this year.



But, but, Ben, the markets will be disappointed. The S&P could fall, interest rates might rise. We wouldn’t want that, would we?



Yeah Ben, we don’t want to upset the apple cart just at the time we have it righted. Remember 1937?



I’ve made up my mind. I will not leave the Fed with a policy that is still in an extreme position. I want to give the new guy a fighting chance. Greenspan did the same thing for me before he handed over the reins.



I’m very sad. I thought we would be able to have fun goosing markets for another two years. Now you’re taking away the punchbowl much earlier than anyone has thought. How will we be able to communicate this to the market? It will be a big shock if we just come out and say that QE is over.



We can control the markets; I’m not worried about that. We’ve being doing it for years now, we should have no trouble doing it for another year.



Gee! What happened to my plan to target monetary policy to unemployment? I thought we agreed to that! Now you’re doing a 180 on us.



I'm not suggesting a 180. We will not reverse any QE. I'll leave that up to who ever sits in this chair next. I would like to bring policy closer to neutral.

We will just have to manage the news flow. We can, and will, control that. We will use our usual sources, guys like Hilsenrath, to help introduce this slowly. After all, we don’t want any knee jerk reactions.


We will sanitize the minutes of this meeting. We can introduce the possibility of a change in policy with the words we use. We just have to vague about it…plant a seed. Yes, we will cause some confusion, but that can’t be helped. Most analysts are so confused at this point, I doubt that too many will take the suggestion we are changing direction seriously.



But, but Ben….this is all coming as a surprise. I’m very disappointed.



(Sobbing) So am I!



Well, all I can say is tough! I have a legacy at the Fed, and I want to preserve that legacy. I will not allow my term at the Fed to end with a policy that must be reversed by someone else on the first day he takes over.


Unless something very significant happens over the next half year, "my" Fed is going to move toward a neutral monetary policy by 2014.


We will continue to drop hints for the next few months, and I will make my final speech in August, at Jackson Hole. I will use that opportunity to confirm what we have agreed to today.



But, but, but Ben….



Drop it Janet. My mind is made up. Meeting over.




Okay, I’m kidding a bit. But this is not so far fetched. Why would the Fed send one signal on December 12 and quite a different one on January 4? When it comes to the Fed, there is always a motive for its actions. The motives are not always clear.


I do believe this development is connected to the “legacy” issue. Bernanke’s term at the Fed will set many historical precedents. To a significant extent, history will judge Bernanke on what he did while chairman of the Fed. But the books will also look at what happened after he left.


I believe that Bernanke would very much like to leave his successor with a Fed that had policy choices. As of today there are no options left. Just more useless QE. I doubt that Bernanke wants to exit with the Fed’s foot planted firmly on the gas pedal. The next guy does deserve a cleaner plate than now exists.


Is the Legacy factor influencing Bernanke? I think it has some sway in his thinking. Consider what Greenspan did before he left. After years of soft monetary policy he ratcheted up the Federal Funds rate 17 times in 22 months. He took the funds rate from 1% all the way up to 6%. Part of that rapid increase was driven to get monetary policy "neutral", so that Bernanke could do as he wished. Not long after Bernanke took over, he took the funds rate down to zero.




Clearly, Greenspan tried to get monetary policy back to neutral before he left, I don’t see any reason why Bernanke would think differently. Are we watching a repeat of history? At a minimum, his legacy, and where he wants the Fed to be when he leaves, is part of Ben's thinking today.


Readers may conclude that I’m all wet with this. That Bernanke’s Fed will never end the easy money policies. And the idea that his legacy has anything to do with current policy is just gas. Readers might be right in that observation. But those who think that the legacy issue is not a factor, have to answer the question, “What the hell happened at that meeting? Why are we getting hints of a change in policy at this time?”

If there is another excuse for the Fed’s apparent change of heart, I would love to hear about it. I can’t come up with anything else. Something has changed, and it isn't the economy. So what is the motivation?



Reading the Fed’s tealeaves is a bit of a fool’s game. The chances of being right are about 50-50. But for the sake of discussion, assume that the Fed was telling the truth this past week. Monetary policy will change over the course of the year. It will go from 4th gear and full gas, to “neutral”.


When I say neutral, I mean that the monthly QE programs would come to a gradual end. It’s even possible that there could be some very small backup in the Federal Funds rate early in 2014. To me, this sets up a very interesting scenario.


There are two schools of thought on the Fed’s QE activity:


– All of the Fed Governors (specifically, Bernanke and Yellen) have stated their belief that it is the size of the Fed’s balance sheet that matters when it comes to measuring monetary stimulus. The vast number of folks who opine on the Fed, also believe this is the case. So the markets, and the Fed believe that “neutral” means that the Fed’s balance sheet remains static.


– A small, but vocal minority, lead by Tyler Durden at Zero Hedge, see it differently. This group believes that it is not the size of the Fed’s balance sheet that is the issue. It is the daily, weekly, monthly flows that the Fed creates with QE that is the critical metric when measuring monetary policy.



The two different views are remarkably divergent in their conclusions. And only one camp will be proven right.


I happen to agree with Durden. It’s the flow, not the size. We have a capital market that has a $20B “bid” in it every week. With each POMO buy, the primary dealers have cash money in their pockets, and they have to spend it. So they buy “stuff”. The stuff they buy with the loot from QE ranges from Treasuries, to junk, to equities. I believe that the constant demand from the Fed is the gas that makes these transactions happen. I believe that when POMO stops, so does the merry-go-round.


The Fed will not stop QE abruptly. There will be a 3-6 month wind-down of the POMO buys. We have been here before, with QE1. Well before the Fed stopped buying, markets started to react to what was then perceived to be the end of the QE party.


To a significant extent, this question, and how the markets answer it, will resolve the fate of the markets, the broader economy and Bernanke’s legacy. So this is a very big deal.


The view of the Fed, that it is balance sheet size not flow that matters, is supported by 95% of the market today. So when Steve Liesman tells you that the Fed is moving to “neutral”, and that’s not a big deal, be wary. The "consensus view" is rarely right in these matters. I think the Fed’s neutral is going to feel as if we are in reverse, and moving backwards pretty fast.


Note: I have long felt that Greenspan's rapid reversal of the Funds rate in 2006 led to the collapse in 2008. Alan tried to "regularize" what he did after the Dotcom bust. Bust went to bust as a result.



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