Ben Bernanke has been chairman of the President's Council of Economic Advisers since June 21, 2005, and this may have been, in effect, his job interview for the Federal Reserve chair. Prior to his CEA appointment, he served as a member of the Federal Reserve Board of Governors between Aug. 2, 2002, and June 21, 2005, and may have been the architect of Fed policy during this tenure.

Bernanke believes in a monetary policy that is pre-emptive against a possible deflationary cycle, as "prevention of deflation is preferable to cure." Bernanke believes in gradual steps to raise and lower the federal funds rate. Most economists say that Bernanke will conduct monetary policy through inflation targeting. These are the issues that today's questions from the Senate Banking Committee should focus on.

While most Wall Street economists view Bernanke's Federal Reserve policy background positively, I have my reservations.

On Preventing Deflation

While Bernanke was a Federal Reserve Board member, he gave a speech on Nov. 21, 2002 titled, "Deflation: Making Sure 'It' Doesn't Happen Here." This timeline is significant, as the FOMC became concerned about deflation shortly after this speech and pushed the federal funds rate down to 1% in June 2003 to thwart that threat. What concerns me is that Bernanke's ideas had the Federal Reserve manipulating market yields, not the market forces of capitalism.
  • To prevent deflation, Bernanke would have the Fed announce explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). This would be reinforced by unlimited open market purchases of the targeted securities at prices equivalent to the targeted yields. Capitalism is based upon market supply and demand forces, and controlling this is manipulating a basic market principle. What happens when the Fed decides to exit this strategy -- who will be left holding the bag?
  • A second policy option Bernanke cited to prevent deflation would be for the Fed to offer fixed-term loans to banks at low or zero interest, with a wide range of private assets as eligible private sector debt (including, among others, corporate bonds, commercial paper, bank loans, and mortgages). The problem with this is what happens to the companies that don't make the list? The Fed would thus become the rating agency. This is another red flag, raising the major question of how the Fed would exit this strategy.

In my judgment, the policy that pushed the federal funds rate to 1% in June 2003 was influenced by this speech by Bernanke. A story from the Associated Press this morning agrees with this: "Heeding the warning, the Fed ended up pushing interest rates even lower."

When the Federal Reserve pushed the funds down to 1%, they pumped up the bubbles in crude oil, commodities, and real estate. The FOMC hence franchised commodity and real estate speculation.

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