Bernanke's Biggest Challenge

Pat Dorsey: Hi. I'm Pat Dorsey, director of equity research at Morningstar. This morning, the White House announced that it would be renominating Chairman Ben Bernanke to head up the Fed; not a great surprise, but one which has some interesting implications for the path of the economy going forward.

I have with me the associate director for our banking team, Matt Warren, to talk through what Bernanke has done so far, and, more importantly, what he might do in the future.

Thanks for joining me, Matt.

Matthew Warren: Good to be here.

Dorsey: So, not a big surprise.

Warren: No, not at all. There were a couple other minor mentions. I think, people think that Larry Summers is interested in the job at some point in the future, and some minor mentions of Janet Yellen as maybe a future Fed chief as well. But, I think everybody was looking for this to happen.

Dorsey: Right, and Summers would just be too overtly political. I mean, he's too closely tied to the administration to be conceived in any way as independent.

Warren: Yes, I think that's exactly right. You would have fears that we were just monetizing the debt-fueled spending, and that would amplify those concerns.

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Dorsey: Now, it's important to note that Bernanke has been nominated, but he hasn't been confirmed yet. We see Supreme Court justices shot down in nomination hearings now and then. That doesn't really happen though with Fed chairmen.

Warren: Not to my knowledge. But I really would be surprised to see something like that happen. There's no obvious second choice necessarily, and I think the markets would not like to deal with that kind of uncertainty, for sure.

Dorsey: Yes, uncertainty has not been something the markets have dealt with very well over the past six to nine months.

Warren: That's right.

Dorsey: Let's talk about the way forward now. Bernanke's got a huge challenge ahead of him. One can credibly argue that he and his compadres did a pretty decent job last fall getting liquidity into the system and averting what could have been gone from a big "R" recession to a small "d" or a big "D" depression.

Now what?

Warren: I think what you said there upfront is really important. We were on the cusp of a very nasty situation. I personally attribute our moving away from the abyss to the Fed and quantitative easing, to the bank stress test, and really not letting a large major financial institution fail after Lehman.

In my mind, it was those three things that were critical to jump-starting us from next to the abyss to where we are now, so he's done a great job there.

In terms of going forward...

Dorsey: The big question is how do they shrink their balance sheet, right?

Warren: Yes, it doesn't get easier from here, I don't think. So, you kind of go into uncharted territory. There have been very few parallels in the past once you get down this road of quantitative easing.

We're trying to support asset markets now and keep them from collapsing. The economy seems to be on the mend, even if it's a slow process and there are revenue growth concerns and whatnot.

It's going to be very tricky because if you pull back too fast, you could have the asset markets collapse again. We've really become dependent on those low rates to get us through this juncture.

Dorsey: It's interesting to note that in the latest senior loan officer survey, the demand for credit is still quite low when you would expect with rates this low, there'd be a higher demand.

Forget about supply. Forget about bankers tightening up their lending standards amidst a bad recession. People just don't want to take on credit at either the consumer or corporate level.

Warren: Yes, I think we used up all that latent demand in the last time we were trying to save the economy back in '03. I think that's a really legitimate concern.

If you look at Japan, which is one parallel, they became very dependent on low rates, and every time rates would move north, it would stall the economy out again.

If you look at the Great Depression in 1937 or so when they looked to remove some of the stimulus--arguably, they did it too fast then, and it sent the economy into a huge tailspin again. That's the concern that Bernanke's faced with.

Dorsey: What would, in your mind, be the biggest challenge going forward? Certainly, it sounds like keeping rates low for a long time seems like the most likely scenario.

Whether or not the Fed continues its process of purchasing Treasuries and other securities to keep those prices supported and the rates down, there are other programs that could be reined in at some point.

Amidst all this tangled mess, where would you be focusing the most attention?

Warren: If I have to look to the future and put my best guess on it, they're going to discontinue the Treasury buybacks. That's too big of a market to have an impact unless you went big guns, which is very risky and doesn't seem necessary at this point in time.

In terms of buying agency paper and trying to buy down the mortgage rate, they're going to have to be very careful in backing off of that program because the housing market is awfully fragile.

We're going into the off-season here. They definitely need to support the market through the off-season in my opinion and see how things go in the next buying season because we really still need to work down that inventory. So, it's going to be tough to not continue buying some mortgage debt for the near term.

Then on the rates itself, I really do think we're going to be stuck with awfully low rates for the near term and into the medium term, in my opinion. If you were to spike those rates, the overleveraged consumer, you'd see a surge of defaults again there.

There are overleveraged corporates that couldn't handle a rise in rates. There are a lot of overleveraged commercial real estate owners that would really struggle with higher rates, so you need to keep those rates low to let people mend their balance sheets in the interim.

Dorsey: And then that takes time.

Warren: It sure does.

Dorsey: Great stuff, Matt. Thanks for joining me.

Warren: Sure thing.

Dorsey: I'm Pat Dorsey, and thanks for watching.