Washington Matters


Bernanke Takes Criticism But Keeps On Going


Part of life as chairman of the Federal Reserve is dealing with barbs from U.S. critics, But it comes a surprise when a blast comes from overseas, this week from German Chancellor Angela Merkel.

Merkel aimed a broadside at Ben Bernanke, whom she faulted for flooding the financial markets with too much money, setting the stage for a surge of inflation.

Germans especially have been worried about currencies crashing since they went through hyperinflation after World War I. Americans carry their own mental baggage, but it's the image of breadlines amid 25% unemployment during the 1930s. So, while the Fed is taking bold measures to avert another Great Depression, Merkel raises renewed concerns about inflation. Of course, Merkel is up for re-election in September, and it's possible she's laying a foundation to say, "Don't blame me for an economic mess, it's the Fed's fault."

No matter. Bernanke won't debate her, but he can't ignore the issue. Fed chairmen say almost every chance they get that they worry about inflation and will act quickly to prevent it from surging. They have to assert vigilance repeatedly, which Bernanke did again in testimony Wednesday before the House Budget Committee. The Fed knows that confidence is very important. If U.S. and foreign investors think that the Fed will tolerate even a little inflation, the result is a rise in interest rates to compensate them for the risk that inflation will occur despite what a Fed chairman says.

It's not easy for the Fed to pursue goals of encouraging job growth and at the same time keeping prices under control. Bond investors have their own vivid memories, and they worry about a rerun of the 1970s when the Consumer Price Index hit 12% one year. They remember a Fed that talked tough but didn't tighten credit until Paul Volcker took over as chairman in 1979. While there's never a good time for the debate to flare up, the timing now is delicate. If rates rise much from current levels, that would discourage borrowing by businesses and consumers and threaten to short-circuit what appears to be the end of the U.S. recession this summer

The financial markets are starting to bet that the U.S. government, including the Fed, won't be able to wind down involvement in investment banks, insurance companies, automakers and other businesses in the kind of orderly fashion that might keep inflation from accelerating. Bernanke has some fans, including Rep. Barney Frank (D-Mass.) who says he isn't worried about inflation because he believes that Bernanke has worked out an exit plan.

The bet here is that Bernanke probably does have a good plan to withdraw from involvement in various companies and take back some of the credit that's been extended. But the reality is sure to be messy, full of unforeseen events. As a result, there will be some increase, if only temporary, in long-term interest rates.

Adding to the risks is the likelihood that President Obama will decide to replace Bernanke when his term as Fed chairman ends next January. No matter who Obama appoints (with the exception of Volcker who turns 82 in Sept.) investors will see the change as nudging the Fed toward policy that will tolerate any big borrowing needs that arise from Obama's ambitious plans from health care reform to climate change to winning a war in Afghanistan.

Given the increase in borrowing to finance the U.S. budget deficit, and given signs that 2010 may bring a global recover, all the stars are lining up in the direction of higher inflation. That's why a best-case outlook seems to be a floor of 3.5% for the 10-year Treasury, with the rate rising to 4% by the end of this year, and continuing to rise during 2010.

 




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