Bernanke bonus mustnt make hedge-fund guys blush

Written by Mark Gilbert | Updated: Aug 28 2009, 05:55am hrs
Ben Bernanke's renomination as Federal Reserve chairman gives him a guaranteed job for four years, precisely the kind of long-term, risk-free tenure that regulators are trying to outlaw elsewhere in finance. President Barack Obama was always going to leave Bernanke in the saddle, even if he does lack the all-important "Alumnus of Goldman Sachs Group Inc." qualification that seems to be a prerequisite for anyone wanting to run anything in the United States of Keynesian Experimentation. Working out what bonus, if any, Bernanke might merit for his eight years steering the world's biggest economy, though, is a tricky task.

Sure, he seems to have avoided another Depression. But with the Group of 20 industrialized and emerging nations pumping about $12 trillion through the crash-cart paddles, according to data compiled by the International Monetary Fund, it would be almost impossible for the global economy not to start twitching back into something resembling animation.

The question remains what those various stimulus packages will eventually do to the inflation outlook. One of the prime causes of the bubble spawning the crunch that wrecked the economy was the Fed leaving borrowing costs too low for too long; repeating that experiment is a high-risk strategy.

"The commitment to low rates is designed to keep inflation from falling and falling persistently below what we might want it to be for a long time," Fed vice-chairman Donald Kohn said during an audience-debate period at the central banker gathering hosted by the Fed at Jackson Hole, Wyoming, last week.

Ending a recession is expensive. The US federal budget deficit will run to $1.6 trillion this year, the Congressional Budget Office said on Wednesday, equal to 11.2% of the economy. That's the biggest gap since World War II. Unemployment, meantime, will surge to 10.2% next year. Government spending has climbed by $700 billion, a 24% jump, for the biggest annual increase in more than half a decade as policy makers try to remedy the credit crisis.

If the US was a hedge fund, investors would be racing to get their cash out. There's no sign yet that Bernanke will deviate from the strategy he has been pursuing for almost a year by making money as free as it can be to goose the economy. Paul McCulley, who helps oversee the world's biggest bond funds as a partner at Pacific Investment Management Co., reckons the Fed will keep its target interest rate unchanged at zero to 0.25% into 2011. What does that mean for consumer prices

It's time to turn once more to the Fed's excellent fantasy policy game, "So You Want to Be in Charge of Monetary Policy" available on the San Francisco Fed's Web site.

The interactive game has had a few tweaks since I last played it in February 2008 (after which it mysteriously disappeared from the site for a while). Back then, the site unashamedly said getting reappointed to the job of Fed chairman was the aim of the game; now it says we are trying to keep inflation at about 2% and unemployment near 5%.

The game commences with a Fed funds rate of 4.5%, a 4.75% jobless rate, and prices that are rising 2.14% a year. The screen lets you tweak the benchmark interest rate only once every three months. That's good enough for our purposes; if Pimco's McCulley is correct and the Fed keeps monetary policy unchanged until 2011, money will have been almost free for two years.

So, all we have to do is whack the Fed funds rate down to 0.25%, leave it there for eight consecutive quarters, and let the computer program tell us what happens to the economy when the cash spigots are opened and left running.

After a year with a 0.25% borrowing rate, the Fed model shows an economy very different from the one we currently see. Inflation spikes to 3.3%, rather than the 2.1% drop in prices recorded in July. The jobless rate, meantime, collapses to 1.94%, a far cry from the 9.4% level in July.

Following two full years of near-free money, the Fed's game suggests that the inflation rate will soar to 8.1% as unemployment dives to 1.5%, which is the minimum that the model allows.

At this week's renomination announcement, both Obama and Bernanke appeared without ties, their open-necked white shirts making them look like smug Hedge-Fund Guys. So far, the returns on the fund they run are far from stellar.

Should Obama's faith in Bernanke prove to be misplaced, and Bernanke's seeming obsession with deflation blind him to the risks of inflation, even Bernard Madoff's funds may look like a safer place to entrust your savings than US markets.

For now, at least, Bernanke's bonus should be deferred -- and paid in Treasuries, giving him a direct stake in how inflation turns out.

(Mark Gilbert is the London bureau chief and a columnist for Bloomberg News. The opinions expressed are his own.)