Wall Street Whispers: Bernanke, Get A Clue

So far, the Fed's assurances that money will stay cheap indefinitely may actually be stunting growth.
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NEW YORK (

TheStreet

) -- This is Ben Bernanke's time to shine -- or utterly fail.

The

Federal Reserve

chairman is facing an unenviable challenge ahead of him: How can he get the economy to grow when no one wants to borrow or lend?

So far, the Fed's assurances that money

will stay cheap indefinitely haven't been doing much good. Bernanke's statement last week that the government is prepared to take even more dramatic steps than setting its rate target at 0% to 0.25% sent rate futures tumbling even further.

Federal Reserve Chairman Ben Bernanke may be waiting too long to fight the deflation battle.

None of this bodes well for consumers, the financial industry or U.S. economic growth.

The Fed's two main purposes are thus: To keep the cost of living in a moderate range while promoting economic growth and to keep the jobless rate down. So far, Bernanke's crew is failing on the jobs mandate and teetering near failure on the cost-growth dynamic. In fact, the Fed's cheap-money policy may now be stunting growth.

For instance, since April 2009, more than 7 million mortgages have been adjusted into lower rates, according to the Treasury Department, saving consumers $12.7 billion in interest payments.

But consumers haven't been blowing their extra dough at the mall; they've been saving the cash or paying down other debts. Since the financial crisis first blew up, the personal savings rate has more than tripled to above 6% from roughly 2%. Meanwhile, revolving consumer credit - credit cards and the like - has declined by a whopping 14% to $826.5 billion.

As far as employment goes, 4.2 million U.S. jobs have been lost on a net basis under Bernanke's tenure so far, according to the Labor Department. The unemployment rate remains stubbornly high -- 9.5% if one goes by the official government statistic or

above 20% if one factors in all of those who are out of work.

While jobs and spending have grabbed Main Street's attention, a more ghoulish threat may be lurking ahead.

During Bernanke's first term, consumers faced price increases above 5%, with gasoline topping $5 per gallon in certain parts of the country and food prices rising in kind. There were endless reports of workers and companies struggling to make ends meet due to higher costs for travel and food - suburbanites with long commutes, farmers hauling hay, executives reliant on airline travel, low-income parents who needed to put food on the table.

Now, as economic growth has slowed and the jobless rate remains high, there's increasing consensus in the market that the country

may enter a deflationary period, which could have even more disastrous results. (See:

Japan for reference.)

The Fed's key interest-rate target is such that banks can access funding for free or close to nothing. Money from the Fed window costs 0% to 0.25% and typical consumer deposits cost a similar amount.

Banks can take those cheap funds and reap fat margins just by buying government debt. Long-term Treasury bills are yielding 2.5% to 4%, while long-term municipal bonds can deliver up to 5%, depending on the duration and rating. The industry also has an appetite for investment-grade corporate bonds, which are yielding anywhere from 1.5% to 3% on the short end, and 3.5% to 6% on the long end.

Wherever the banks are putting the cheap money, they certainly aren't lending it to consumers, unless the debt is backed by a government guarantee. That's a function of demand as well as desire, but the weak lending environment hasn't yet bitten into banks' profit margins.

The country's four largest lenders,

Bank of America

(BAC) - Get Report

,

Wells Fargo

(WFC) - Get Report

,

JPMorgan Chase

(JPM) - Get Report

and

Citigroup

(C) - Get Report

, earned $13.7 billion last quarter. They have been operating in a much sunnier environment for the past six quarters than anyone could have imagined during the dark days of 2008.

A combination of low funding costs, mortgage fees and government backstops on various kinds of debt have delivered strong profits for major industry players. As a result, banks have had little incentive to move further out the risk spectrum into consumer or small-business lending.

The Fed has effectively supported this trend by repeatedly pledging an "extended period" of low rates. But the weak economic outlook has led the market to price in low rates for a lot longer than the Fed (or the banks) had wanted.

Long-term Treasury yields recently hit fresh lows and 30-year fixed mortgage rates fell last week to an all-time low of 4.36%. Since the start of the year, the difference between the Treasury's short-term debt and its long-term debt has plunged by an entire percentage point.

Comments during big banks' second-quarter earnings calls hinted that the so-called "yield-curve flattening" had already begun eating into their collective bottom line.

The value of Bank of America's hedging portfolio dropped by $4 billion; JPMorgan stunned some analysts with a net interest income decline of $1 billion; and Wells' typically prosperous rate-hedging strategy delivered $300 million less than the previous quarter.

"There might be a point in time we have a view that rates can't go much lower and they are going to go up; we might have a bias," Wells Fargo CEO John Stumpf explained in July. "... But we sat here just a quarter ago and rates were 100 basis points higher. People said at the time it couldn't go any lower and it went 100 basis points lower."

JPMorgan CEO Jamie Dimon indicated that the firm had begun "repositioning" securities holdings to keep up with the market.

Since that time, rates have only dropped further.

Reading the tea leaves of the Fed's current policy isn't difficult. Bernanke seems to assume that if rates stay low enough long enough, people will

have to

want to borrow and banks will

have to

push out further into the risk spectrum to get a little more yield.

As an expert in the Great Depression who has studied solutions to Japan's current deflationary debacle, Bernanke may well be right. But so far the strategy hasn't had sustained success and it's now threatening a fledgling recovery that had just poked its head out of the muck.

Only one colleague at the Fed's board of governors, Kansas City Fed-Bank President Thomas Hoenig, appears ready to change course.

"A zero policy rate during a crisis is understandable, but a zero rate after a year of recovery gives legitimacy to questions about the sustainability of the recovery and adds to uncertainty," Hoenig said at a recent event. "Of course the market wants zero rates to continue indefinitely: They are earning a guaranteed return on free money from the Fed by lending it back to the government through securities purchases."

Hoenig has gained a reputation as a deficit hawk, though he's essentially pointing out the obvious in that speech. He's also become the Lone Dissenter -- the only one of seven Fed board members to vote against his colleagues at all five policy meetings this year in an effort to remove language that suggests the Fed will keep rates low indefinitely.

Hoenig's proposition is a risky one. If the Fed raises rates, or suggests that it will, it might stymie growth even more. But it also might boost confidence enough among buyers, sellers, borrowers and lenders to get hiring and growth started up again. It would certainly accomplish the task of pushing banks further into the risk spectrum more quickly - if only by necessity - than current policy has.

In discussing Japan's deflationary environment over seven years ago, Bernanke advised regulators to consider setting a higher price target in order to "actively reflat

e the economy."

"Indeed, a definitive end to the deflation in consumer prices -- by restoring confidence and stimulating spending -- would do much to help moderate the unemployment and financial distress that might otherwise arise," Bernanke, then a Fed governor, said during a speech in Tokyo in May 2003.

The Bank of Japan finally started responding to rate criticism just before the global crisis erupted 2008, so their rate hikes did little good for the economy.

Of course the U.S. isn't Japan -- at least not yet -- and may never turn out that way. But it's inarguable that growth and prices are coming under pressure. Last week, the Commerce Department slashed its second-quarter GDP figure to 1.6% from an initial estimate of 2.4%. The market considered this a good thing, having expected an even greater decline.

In considering his options, Bernanke may also want to take a cue from two of his predecessors: Alan Greenspan and Paul Volcker. Greenspan held rates low for an extended period of time to stimulate growth. He was incredibly popular then, considered a mystical monetary genius. Paul Volcker drove the federal-funds rate target up to 20% during the 1970s to stem inflation. He was incredibly unpopular then, with President Nixon prodding him to ease up.

While Greenspan fomented the current fiscal nightmare by keeping rates unnecessarily low, Volcker's strategy was successful. He was re-appointed by President Reagan, serves as a chief economic adviser to President Obama and now has a law named after him.

--Written by Lauren Tara LaCapra in New York.

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