Don't Give Bernanke Any More Credit

The Fed chairman steered clear of major issues Wednesday.

Merk Investments

IN HIS SPEECH TO THE National Press Club, Federal Reserve (Fed) Chairman Bernanke gave an overview of the impact of the various unconventional lending programs on the Fed's balance sheet. His efforts are aimed at taming concerns about the growth of the Fed's balance sheet, the credit risk the Fed is taking on as well as concerns about the Fed's communication strategy.

While Bernanke was clear that many of the Fed's programs could be phased out, he did not address two major issues:

• Some programs cannot be easily phased out. We are particularly concerned about the mortgage-backed securities (MBS) purchase programs. [It is likely] $500 billion will be spent by the summer, possibly more later; we cannot see how these securities can easily, if ever, be offloaded to the market again. In our view, these are permanent additions -- almost a doubling from the base before the start of the credit crisis; these additions are inflationary unless otherwise sterilized.

• The Fed says it can unwind the monetary accommodation; the Fed also has said in the past that the Fed knows how to fight inflation. But if policies do not encourage a reduction in consumer debt, how can the Fed possibly unwind its programs without severe consequences to the economy? At some point, the fiscal and monetary stimulus will stick; for a variety of reasons, we believe these programs will start to work much later, be less efficient and thus more inflationary than many anticipate, but at some point they will generate economic growth and inflationary pressures. In our assessment, it will simply not be possible to introduce [former Fed Chairman Paul] Volcker-style policies as in the early 1980s to fight inflation. The economy would, in our assessment, come crashing back down. In the "best case" scenario, we foresee a highly volatile Fed policy where initial tightening will need to be followed up by dramatic easing.

Fed Chairman Bernanke also claimed that the credit risks assumed by the Fed are rather small. At this stage, it is our understanding, the Fed is trying to hire staff to weed through the various assets they have acquired. We do not believe the Fed has a full assessment of the credit risk they are exposed to; this was also highlighted by Bernanke's comments that the risks of not acting would have been great -- that may be an explanation or excuse, but not an assurance that the Fed has not assumed substantial credit risk.

Finally, Bernanke tried to assure the public that its activities do not affect the federal budget negatively; instead that interest that the Fed will be paying will benefit the budget. That sounded like John Law giving a sales pitch as any interest paid is nothing but printed money. The Fed's activities are "off-balance sheet" from the Treasury; the Fed is an off-balance-sheet way for Congress to spend more money and the main reason why Congress has not provided more scrutiny on the Fed's programs. We are rather concerned, however, that as the Fed is deviating more from its traditional role by engaging in specific credit allocation to industries and sectors, the Fed is engaged in fiscal rather than monetary policy. That, in turn, is likely to expose the Fed to the ire of Congress and the public, ultimately damaging the credibility and effectiveness of the Fed.

--Axel Merk, president and chief investment officer