An open letter from Stephen Roach to Ben Bernanke!

Dear Ben,

It’s time to take a deep breath. You are off to a rocky start as Chairman of the world’s most powerful central bank. Your policies are not the problem. Given the über accommodative legacy you inherited from your legendary predecessor, the three 25 bp rate hikes in each of the three policy meetings you have chaired have made good sense. The issue is more subtle —- your ability to send a consistent message to financial markets. This is a critical element of your job description. It defines your credibility as a policy maker as well as the credibility of the great institution you now lead. In the end, without credibility, a central bank is nothing.

You know this, of course. As one of the world’s leading academic apostles of inflation targeting, you have long stressed the merits of anchoring financial market expectations of monetary policy with a simple price rule. With price stability now widely accepted as the sine qua non of central banking and with core inflation rates in the US and around the world not all that far away from the hallowed ground of price stability, there is considerable merit in underscoring a determination to preserve the hard-won gains of the past 25 years. This could well be your golden opportunity.

With all due respect, Ben, you are close to squandering that opportunity. A transparent policy rule has real merit in minimizing unexpected and undesired swings in financial markets. But any such rule is as good as its disciplinarians — the central bankers who are charged with delivering the message to the public at large. It pains me to say this, but your message has been all over the place.

What I am alluding to are several reversals in your official pronouncements in the past couple of months. It all started with your 27 April testimony before the Joint Economic Committee of the US Congress, where you openly entertained the possibility of an “unjustified pause” in the Fed’s monetary tightening campaign. That was followed by your 5 June speech at an International Monetary Conference in Washington DC that sent a clear warning about your concerns over “unwelcome developments” on the inflation front. Then there was the policy statement immediately after the 28-29 June FOMC meeting, underscoring the Fed’s forecast that a “…moderation in the growth of aggregate demand should help to limit inflation pressures over time.” Nuanced or not, in this brief two-month time span, your official statements have gone from dovish to hawkish and back to dovish again. Such inconsistencies raise serious questions about your credibility as the world’s leading monetary policy maker.

Speaking of that, you and your colleagues at the Fed must be mindful of the international context and consequences of your posture. Your back-and-forth waffling comes at a critical juncture in the global monetary tightening cycle. Jean-Claude Trichet of the ECB surprised the markets with his own tough talk last week — in effect, pre-announcing another rate hike for August, a month when Europe is normally at the beach. At the same time, the Bank of Japan’s Governor Toshihiko Fukui has also been talking tough for several months, signaling the end of a seven-year zero-interest rate regime and the onset of a long-awaited normalization of Japanese monetary policy. His first step could well be imminent — most likely at the BOJ’s upcoming 14 July policy meeting.

Ben, that puts the consequences of your recent reversals in a very different context. Global investors are perfectly comfortable with the notion that the Fed, which began its tightening campaign long before other major central banks, would be the first to attain its objectives. The idea of the “policy catch-up” by foreign central banks has long been embedded in the consensus view of a cyclical dollar weakening. However, to the extent that the European and Japanese central banks stay on message while you do not, the monetary policy credibility factor could well shift away from the United States. Given America’s outsize current account deficit, a relative credibility erosion could spell sharp downward risks to the dollar — and equally sharp upside risks to real long-term US interest rates. That’s the last thing an asset-dependent, overly-indebted US consumer needs. A resumption of the greenback’s weakness in recent days suggests that you can’t take this possibility lightly.

It was always going to be difficult to wean the markets from the measured Fed tightening campaign that has unfolded without interruption over the past 24 months. When the federal funds rate was 1% in June 2004, the next move was a no-brainer. But now at 5.25%, it is obviously much trickier. The key for you is not to let your understandable sense of uncertainty over the economic and inflation outlook morph into an on-again, off-again assessment of policy risks. This was supposed to be the sweet spot in the policy cycle for inflation targeters like yourself. Lay out the metric you are targeting, provide a clear assessment of the risks, and then let the policy rule generate the unambiguous answer. Easier said than done, I guess.

I think the best thing you can do at this point is to borrow a page from the Greenspan era and make a simple statement of your policy bias. For example, as long as you perceive inflation risks to be on the upside of your tolerance zone, you and your colleagues can endorse a tightening bias. Conversely, if inflation risks tip to the downside, it may be appropriate at some point to announce an easing bias. The bias statement works best when the policy rate is near the so-called neutrality threshold. It is less appropriate when the overnight lending rate is far away from such an equilibrium. In the current context, the verdict would be clear — a tightening bias is in order until inflation risks recede. There’s nothing automatically actionable about such a bias that locks you into a move at each and every policy meeting. There is ample leeway to pass on a policy move and still maintain your concerns.

There may well be a silver lining in your unfortunate experience of the past couple of months. Central banking is as much art as it is science. In that vein, it is equally important to be mindful of one of the major pitfalls of the current financial market climate — seven years of one asset bubble after another, driven by the mother of all liquidity cycles. It is high time to bring this dangerous state of affairs to an end. These are the same bubbles that spawn wealth-dependent distortions to saving and massive global imbalances. Not only must you commit to price stability in the narrow sense of your CPI target, but you and your central banking colleagues in Europe, Japan, and China must be equally willing to commit to an orderly withdrawal of excess liquidity in order to put a seriously unbalanced world on safer footing. That underscores my recommendation to maintain a tighter policy bias at low rates of inflation than a strict price rule might otherwise imply. If that’s what it takes to break the moral hazard of the “Greenspan put,” it is a risk well worth taking.

I guess in retrospect we should have seen this coming. After all, history tells us that transitions to a new Fed Chairman invariably don’t go well. The “transition curse” saw the equity market quickly challenging Alan Greenspan with the Crash of 1987, the bond market promptly testing Paul Volcker, and a dollar crisis immediately confronting G. William Miller. The so-called risk reduction trade, which commenced in early May, could well go down in history as the Bernanke test. There’s nothing like unforgiving financial markets to find the Achilles’ heel of a new central banker.

The good news is that you have another important chance to recover your credibility — your midyear appearance in front of the US Congress slated for 19 July. The bad news is that this may be your last chance for a while. A third reversal could well spell a serious and damaging setback to Fed credibility. A serial bubble blower was bad enough — the last thing world financial markets need is a serial flip-flopper.

Sincerely,

Stephen S. Roach

Chief Economist

Morgan Stanley