Friday, October 05, 2007

Anatomy of a Fabulous Fed Flip-Flop

My latest syndicated column on how Bernanke’s major-league monetary makeover changes everything.

In politics and on the campaign trail, flip-flops can be very damaging. But Ben Bernanke’s whopper of a policy flip-flop two months ago turned out to be a big positive for financial markets and the economy, and may even help reverse the sinking fortunes of the GOP.

The flip-flop itself is a tale of two Bernanke’s: On the afternoon of August 7, the Federal Reserve chair was an inflation hawk — according to the unchanged FOMC policy statement — fearful of adding liquidity to the markets. By day’s end on August 9, however, he was leading the liquidity charge, initiating a process that would help unlock the credit seize-up that started in late-July.

Why the 180?

Using the Freedom of Information Act, Ken Thomas, researcher and lecturer at the University of Pennsylvania’s Wharton school, was able to get Bernanke’s calendar of phone calls and meetings at the time the flip-flop occurred. He found that a day after the Fed’s August 7 decision to keep rates steady and maintain a focus on inflation worries, Bernanke received a phone call from Citigroup’s Robert Rubin, the Wall Street powerhouse and former Clinton Treasury secretary. Thomas does not know the content of the Rubin call, but subsequent calls and events suggest that Bernanke rapidly changed his mind on August 8 and 9, after which he began steering the Fed towards a series of massive money additions to the banking system.

According to the Bernanke logs, a 5 p.m. Rubin call on August 8 was followed by a 7:30 a.m. next-day breakfast with Bush Treasury man Henry Paulson and an 11 a.m. meeting with legendary mortgage expert Lou Ranieri. (It was Ranieri who pioneered mortgage-backed securitizations, the very bonds that were collapsing as a result of the subprime mortgage virus that had already begun infecting the financial system.) At 2 p.m. that day the Fed chair met with Ray Dalio, head of Bridgewater, the fourth-largest U.S. hedge fund, along with other hedge-fund magnates. At 4:30 p.m., Bernanke was on a conference call with his fellow FOMC members, undoubtedly to discuss a Fed change of heart.

In fact, over the next few weeks, Bernanke participated in no fewer than thirty-five separate conference calls with fellow Fed operatives — a complete departure from his earlier no-conference-call style. And he got the liquidity ball rolling. As we now know, the Fed started pouring liquidity into the system on August 9. Then, on August 17, it slashed its base discount rate for member-bank loans by 50 basis points. Finally, on September 18, it enacted a shock-and-awe liquidity-adding half-point drop in the federal funds rate.

The Bernanke narrative is based on the incidence of calls and meetings, and not the actual content. But it seems clear that Rubin started a chain reaction on August 8 — only one day after the Fed’s disappointing, hold-the line policy decision that so disappointed financial markets and intensified the credit turmoil. Essentially, the academic Bernanke became a hands-on market participant through his contacts with Rubin, Paulson, the hedgies, and others. He reached out to savvy financial-market players who put him in touch with the real world. He then embarked on a 5-week journey that shook world credit markets out of their financial panic and started the healing process that continues to this day.

Financial confidence has improved, the credit crunch has loosened, and stock markets worldwide have rebounded dramatically, with the Dow hovering near its high of 14,000. This wipes the 2008 recession scenario off the table. For example, the latest jobs report shows 110,000 new payrolls for September, with the prior two months revised up by 118,000.

In the annals of flip-flops, the Bernanke switch is as good as they come. And not only economically, but politically.

Most pundits believe a prolonged economic downturn would doom any Republican in the presidential race against Sen. Hillary Clinton, the most likely Democratic candidate. The pay-to-play Intrade prediction market puts a 60 percent probability on a Democratic presidential win. Compounding this, a Wall Street Journal poll gives Democrats a 25 percentage-point advantage on cutting budget deficits, a 16 point margin on spending control, a 15 point lead on the economy, and a 9 point advantage on taxes. On top of that, the poll shows a serious Republican loss of business support.

Undoubtedly, an economic recession on top of all this would be gut-wrenching for the GOP. But Bernanke’s major-league monetary makeover, one that re-launched a pro-growth Fed policy to supply ample credit for economic expansion, changes all that.

It would be ironic if Clinton advisor Robert Rubin’s phone call to the Fed chief — a call that triggered a complete monetary about face — wound up bolstering the economy and keeping GOP presidential hopes alive.