When the Fed head speaks, the world listens

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The Gazette, Sunday, July 25, 2010

In his semi-annual testimony before Congress on Wednesday, U.S. Federal Reserve Chairman Ben Bernanke said the prospects for economic recovery were "unusually uncertain."

On those two words, stock markets in North America took the rest of the day off. In New York, the Dow plunged 109 points to close 1.3 per cent lower on the day, while the NASDAQ lost 35 points or 1.6 per cent. In Toronto, the TSX was off 116 points or one per cent, with much of the dip on the hot chart coming in the hour after Bernanke's afternoon testimony.

Such is the power of the chairman of the Fed to move markets. Not since his predecessor, Alan Greenspan, worried about "irrational exuberance," during the 1990s, have two words caused such a commotion in markets. Greenspan was subsequently more circumspect in his pronouncements, and developed an impenetrable vernacular of his own that he called "Fedspeak."

Bernanke's choice of words rattled markets because they are worried about the pace of the recovery and the prospect of the U.S. economy tipping into a double-dip recession. Bernanke offered little comfort, suggesting a modest recovery with "a somewhat weaker outlook."

How weak? Well, he predicted that U.S. unemployment, still flirting with double digits at 9.5 per cent, would remain well above seven per cent through 2012, which just happens to be the year Barack Obama will be up for re-election as president. More than 8.5 million jobs have been lost in the U.S. since the financial crisis and recession hit in the third quarter of 2008, and clearly a lot of them aren't coming back.

And as Bernanke made clear, he doesn't have any tricks up his sleeve, since his monetary policy is "already quite stimulative."

That's putting it mildly. The U.S. Fed fund rate of between 0 and .25 per cent is already at a historic low, and Bernanke is in no hurry to raise interest rates.

He has already pumped record levels of cheap liquidity into the U.S. economy. And Congress would never agree to increase the federal deficit, already $1.6 trillion, or 11 per cent of GDP; and in any event Obama has pledged at the G20 to cut the deficit in half by 2013.

So there aren't many things left in the tool kit in terms of stimulus, either in monetary or fiscal policy. As someone has observed, we've had a blowout, and we're back on the road, but we've used our spare tire.

What Bernanke was really saying to the business community was that they're sitting on a lot of cash, a reported $1.8 trillion, and they should invest some of it. Cash might be king, but it isn't good for the economy.

The pace and prospects for recovery are not just the main economic question of the day, they are driving the political debate in both the U.S. and Canada. The congressional midterm elections are up in November, and the next presidential cycle begins anytime after that. And as James Carville famously wrote in Bill Clinton's war room in 1992: "The economy, stupid!"

In Canada, the recovery is on a roll, with nearly 100,000 jobs created last month, while the U.S. economy lost 125,000 jobs, Unemployment, at eight per cent, while nearly two points higher than pre-recession levels, is moving in the right direction. Inflation is well below the Bank of Canada's target range of two per cent.

And yet, any weakness in the U.S. economy will be reflected in our own. We export one third of everything we produce, with 75 per cent of that going to the U.S. Millions of jobs in this country -from rail to autos to energy -depend directly on exports to the United States.

Still, Bank of Canada governor Mark Carney had the discretion to pass on raising the bank rate last Tuesday, and yet chose to make his second straight increase of 25 basis points to .75 per cent, coming off the stimulative low of .25 per cent.

With employment moving in the right direction, and inflation well in check, he had no need to raise the bank rate, especially with Bernanke standing pat, with no indication of an increase anytime soon.

If anything, a 50 basis point spread with the U.S. bank rate could put even more upward pressure on the loonie, which Carney has on two occasions in the last year tried to talk down as it approached exchange rate parity with the greenback.

Bank economists and others suggest more rate hikes might be looming, but it's hard to know why, other than some excess of Canadian prudence on inflation.

The era of cheap money continues in the U.S., but appears to be coming to an end in Canada.

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