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.

For example, crude oil bottomed out just above $17 per barrel in November 2001, only two months after 9/11. A year later, prices moved above $25, up 47%. The upward speculative momentum for oil took off at the end of 2003 from around $32.50 a barrel, up 91% from the November 2001 bottom. Where was the deflation?

In its ill-advised worries over deflation, the FOMC flooded the world with liquidity, forcing the dollar much lower vs. the euro, and tempted traders and hedge funds to speculate not only on crude oil and commodities, but also on real estate.

Bernanke on Gradualism

The second interesting speech given by Bernanke was on May 20, 2004, titled "Gradualism." This speech set up the measured pace rate hikes that began on June 30, 2004. What's interesting in this speech is that Bernanke viewed gradualism as a better way to control long-term interest rates. But instead it created the "bond conundrum."

Following the May 2004 FOMC meeting at which the FOMC kept the funds rate at 1%, the end of the press release read, "At this juncture, with inflation low and resource use slack, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured." The FOMC told the market that the federal funds rate will begin to be raised at its next meeting on June 30, 2004 in 25 basis point increments. The 30-year yield reached its high point of 5.58% on May 14, 2005, marking the beginning of the bond conundrum.

As a result of keeping rates too low for too long and maintaining an accommodative monetary policy while raising rates, the Federal Reserve funded the bond conundrum and carry trades. Wall Street applauds the Fed and the president's nominee, while Main Street is just starting to feel the pain of higher mortgage rates, higher energy costs and higher property taxes -- all the result of the funds rate being pushed to an artificially low 1%, and the subsequent measured pace of hikes to 4%.

Richard Suttmeier is president of Global Market Consultants, Ltd., chief market strategist for Joseph Stevens & Co., a full service brokerage firm located in Lower Manhattan, and the author of TheStreet.com Technology Report newsletter. At the time of publication, he had no positions in any of the securities mentioned in this column, but holdings can change at any time. Early in his career, Suttmeier became the first U.S. Treasury Bond Trader at Bache. He later began the government bond division at L. F. Rothschild. Suttmeier went on to form Global Market Consultants as an independent third-party research provider, producing reports covering the technicals of the U.S. capital markets. He also has been U.S. Treasury Strategist for Smith Barney and chief financial strategist for William R. Hough. Suttmeier holds a bachelor's degree from the Georgia Institute of Technology and a master's degree from Polytechnic University. Under no circumstances does the information in this commentary represent a recommendation to buy or sell stocks. While he cannot provide investment advice or recommendations, he invites you to send your feedback -- click here to send him an email.

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