Updated from 7:18 a.m. EST
During his confirmation hearing before the Senate Banking Committee Tuesday, Ben Bernanke was given an opportunity for a do-over -- or at least the chance to clear his name.
Asked if he may have drawn any lessons from any particular comments made during his years as a Fed governor, the
Chair nominee didn't hesitate: "In 2003, there was an episode where there was clearly miscommunication between the Federal Reserve and the bond markets
regarding deflation risks and it caused a significant fluctuation in the bond markets," he said. "Clearly there was a misunderstanding about that risk."
This episode crystallized a belief in "the need for greater transparency on the part of the central bank," Bernanke said. But on Wall Street, the important lesson Tuesday was not about the central bank's
but about the man himself.
Without saying it in so many words, Bernanke was telling fixed-income participants that they should abandon any lingering perception about him being a dove on inflation.
Bernanke had been dubbed "helicopter Ben" by some for suggesting during the 2002-03 deflation scare that the Fed could always print money and drop it from helicopters to inject liquidity into the financial system.
His "miscommunication" remarks were made after the bond market closed on Tuesday. But the bond market had already gotten the gist of Bernanke's point earlier when he said, "Currently, inflation is above the range which in the long run would be desirable."
The 10-year Treasury bond gained 12/32 in price while its yield, which moves inversely, fell to 4.56%.
Bernanke's goal was to tell the market that he's not a dove on inflation, because he had that reputation," says Marc Pado, market strategist at Cantor Fitzgerald. "His point is that, even if he has a different methodology
than Alan Greenspan, his goal to maintain price stability remains the same. And what he said was what the bond market wanted to hear."
Since the spike in energy prices that followed hurricanes Katrina's and Rita's hit to energy facilities in the Gulf Coast, long-bond yields have risen sharply. This was due largely to expectations that headline inflation, which includes energy, would eventually seep into core inflation, i.e. excluding food and energy. Such concerns were not borne out in Tuesday's producer price index report but Wednesday's consumer price index for October was higher than expected at 0.2%, leaving the year-over-year increase at 4.3% (albeit down from a 14-year high of 4.7% in September); the core rate also rose 0.2%, in line with expectations and leaving its year-over-year increase at 1.9%. Meanwhile, crude futures hit a
There were also expectations, similarly misplaced, that the Fed might pause or even end its rate hike campaign because of the hurricanes' damage, letting inflation expectations run wild.
Hawkish Fed officials, however, stressed that the economy would withstand the surge in energy prices and that the Fed will continue to hike rates to curb rising inflation pressures and expectations. Chicago Fed President Michael Moskow reiterated the point in a speech Tuesday and Bernanke clearly indicated during his testimony that he shared that mindset.
In the 1970s, there was less confidence about the central bank's ability to contain inflation, and inflationary pressures easily moved from energy to core prices, he said. This, combined with excessive tightening by the Fed at the time, pushed the U.S. economy into recession.
"But in the most recent episode, core inflation remains very well contained. Therefore, the Fed has been able to raise rates to 4% and the economy has still been able to grow strongly," Bernanke said.
When asked about the risk of an energy shock when heating costs hit consumers this winter, Bernanke said the economy was sheltered by "well-anchored inflation expectations."
Expectations about the Fed's future rate hikes were unchanged after Bernanke's morning remarks, according to Miller Tabak. The market still fully expects the Fed to hike rates by another quarter point when it meets on Dec. 13, and sees a 90% chance it will do so again on Jan. 31. This would take the fed funds rate to 4.50%. Fed funds futures are also pricing in a 66% chance that the Fed will again hike rates to 4.75% on March 28.
But while short-term rates have been rising along with expectations of more rate hikes, long-term yields have stopped rising since last week, indicating that inflation expectations might be priced in bond prices for now. The price of gold, which often tracks inflation expectations, has fallen from its recent 18-year high but traded above $470 per ounce intraday Tuesday before settling at $469.
Meanwhile, the yield curve, which plots the yields of short- and long-term bonds, keeps on flattening. The spread between the yield of the two-year government bond -- which closed at 4.46% -- and that of the 10-year has narrowed to 10 basis points. A flattening yield curve points to market expectations of an economic slowdown; outright inversion has historically been a harbinger of recession.
Major averages fell Tuesday, weighed down by weakness in
and financials such as
. This offset strength in names such as
Johnson & Johnson
But the decline was modest for stock proxies and more likely the result of an overextended market retreating after a three-week rally vs. worries about a recession next year, according to Cantor's Pado.
But "at some point, we'll invert the yield curve," Pado says. "The Fed will push rates higher and we may have to withstand a recession, even for a short while, because that's the best thing for the economy in the long run."
A slowdown in the economy next year could be accentuated as consumers take a hit from this winter's heating and credit card bills, he says. In addition, the evident cooling in the housing market will likely diminish homeowners' appetite for home equity extraction, which has fueled much of the consumption binge of the past few years.
During his confirmation hearing, Bernanke also repeated Greenspan's remarks that home price appreciation will likely continue to moderate and cited this as a cause of concern for the economy next year.
In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;
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