Rough Flight Ahead For Helicopter Ben?

The last time a new Federal Reserve Chairman took office, replacing the legendary Paul Volcker on August 11, 1987, not only did he find himself with a big pair of shoes to fill, but he also faced a plunging bond market that would soon send long-term interest rates spiraling into double digits. Desperate to immediately establish his credentials as a staunch inflation fighter, the freshly appointed Alan Greenspan wasted no time in hiking the discount rate on September 4. But only the spectacular stock market crash of October 1987 - and the inevitable recession concerns and "flight to quality" it spawned - managed to quell the fears of bond investors worried about resurgent price pressures under then untested central bank leadership.

Now Greenspan, after presiding over an unprecedented 18-year economic winning streak interrupted only by a pair of relatively brief, shallow recessions, is the outgoing legend and Ben Bernanke, who officially assumed his title last February 1, has stepped in to take Greenspan´s place by raising rates, as expected, in his first act as Fed head on March 28, 2006.

The stock market promptly showed its displeasure by reversing to end the day with a 95-point Dow drop, presumably disappointed that "Helicopter Ben," instead of softening language in the statement that accompanied a 15^th straight quarter-point rise, to 4.75% in the benchmark Fed Funds rate, prepared the markets for further increases. Before the week ended, bond sellers pushed yields on 10-year Treasuries to near 4.9%, the highest since the Fed started its current campaign of tightening in June 2004.

Bernanke, a licensed pilot, earned his aerial moniker from a speech he gave before the National Economists Club in Washington, D.C. on November 21, 2002. In his commentary, delivered a full year after the start of the greatest commodities bull market since the 1970s, the Harvard and MIT-educated economist outlined various policy tools available to the Central Bank if needed to stem deflation, even if short-term interest rates approach zero. In what would become known as the "printing press speech," Bernanke, then a member of the Fed's Board of Governors, declared, "The U.S. government has a technology, called a printing press, that allows it to produce as many dollars as it wishes." He went on to say, "A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices. A money-financed tax cut is essentially equivalent to Milton Friedman's famous 'helicopter drop´ of money."

Following the landmark success of Greenspan´s tenure, during which consumer price inflation was cut in half and unemployment reduced to less than 5%, both the Federal Reserve and its office of Chairman are held in high esteem. Pundits often refer to the Fed Chairman as "the second most powerful man in the world," behind only the President of the United States, but this wasn´t always the case. When Congress approved the Federal Reserve Act on December 23, 1913, it granted almost complete autonomy to the 12 separate Federal Reserve Banks. Each Reserve Bank was free to set its own discount rate and pursue a distinct monetary policy. Benjamin Strong, who ran the Federal Reserve Bank of New York, dominated the Fed from its 1914 inception until his death in 1928. Strong pioneered the use of open-market operations when his bank aggressively purchased government securities to head off a recession in 1923, and employed the technique through much of the decade. The Governor of the Federal Reserve Board, as the central bank chief was then known, exercised little authority. The Secretary of the Treasury, who, along with the Comptroller of the Currency held automatic memberships on the 5-man Board, functioned as chairman at agency meetings, which were held at Treasury Department headquarters in the nation´s capital.

All that changed with the passage of the Banking Act of 1935, which centralized control in the hands of the Federal Reserve´s Board of Governors. The act formalized Strong´s idea by creating the Federal Open Market Committee (FOMC). On March 19, 1936 the FOMC elected Marriner Eccles, a Utah banker who crafted the Depression-era legislation reforming the Fed, as the first Chairman of the reorganized Federal Reserve. Since then, the respective reigns of the various Fed Chairmen have been full of surprises - and accompanying market volatility - especially in the early phases of new leaders´ terms. A look back at the careers of the nation´s top central bankers might show what´s in store for Bernanke.

Marriner Eccles (March 19, 1936 to April 15, 1948): An early proponent of the countercyclical fiscal policy made famous by John Maynard Keynes in his General Theory, Eccles too supported not just increased spending but direct government investment to replace private investment in recessions. He believed the Fed should maintain low rates to facilitate such investment and called his plan "controlled inflation." Nonetheless, Eccles became concerned that excess bank reserves posed an inflationary threat in early 1936. The Banking Act of 1935 authorized the Fed to as much as double reserve requirements above the minimum specified in 1917 without presidential permission, and that´s exactly what Eccles did, in 3 massive steps between August 16, 1936 and May 1, 1937. The severe credit tightening undermined industrial production, which plummeted faster than during the Great Depression in 1929-33. The sharp economic contraction became known as the "Roosevelt Recession."

Thomas McCabe (April 15, 1948 to March 31, 1951): Following its failure to prevent the Great Depression, the Fed - and monetary policy generally - fell into disfavor. As Keynesianism gained adherents, the consensus held that "money doesn´t matter," even though monetarists to this day blame the Fed for allowing the money stock to contract by a third in 1929-33. In April 1942, the FOMC announced its intention to keep interest rates on Treasury Bills at a constant three-eighths of a percent (0.375%) by buying or selling, as necessary, in order to help finance the war effort. Bill rates stayed at those levels through mid-1947. The Fed also intervened to set the rate on long-term government bonds at 2.5%. Although a rollback of World War II price controls in mid-1946 unleashed a burst of inflation, most of the public feared a return of deflation. In the 1949 film Father of the Bride, a young Elizabeth Taylor asks her father and fiancée at the dinner table whether there would soon be another depression. E.A. Goldenweiser, then director of research for the Board of Governors, reflected popular opinion when he dismissed inflation as something "we are likely to escape in this postwar period," and instead fretted over the "problem of finding jobs for people released from the services and war industries."

The outbreak of the Korean War in June 1950 turned that psychology on its head and ignited an inflationary boom. Wholesale prices shot up at a sizzling 22% annualized rate in the second half of the year. Against this backdrop, Chairman Thomas McCabe, a Truman appointee formerly more than willing to take a subordinate role and accommodate the Treasury´s needs, emerged as an unlikely champion of Fed independence. On August 21, 1950 the Board jacked up the discount rate and publicly expressed its intent to let government securities yields rise. The Treasury countered with an advance declaration that it would maintain existing rates in its forthcoming September-October wartime refunding. The Fed was ultimately compelled to purchase most of the refunding issue and would have fueled an explosion in the money supply if not for a largely offsetting outflow of gold, resulting from intense import demand as domestic businesses scrambled to stockpile raw materials. President Harry S. Truman, vehemently opposed to Fed freedom, summoned the entire FOMC to the White House for a meeting and afterward released a false statement that the Fed had pledged, "to maintain stability of government securities as long as the emergency lasts." Eccles, still a Board member, gained a measure of revenge for Truman´s refusal to reappoint him as Chairman by releasing a confidential summary of the meeting, which proved Truman a liar and galvanized support for Fed independence.

The ongoing conflict between the branches of government led to the Treasury-Federal Reserve Accord, issued on March 4, 1951, which minimized monetization of public debt. Two years later, the Fed would formally abandon its policy of capping government securities yields. Treasury Secretary John Snyder told Truman he could no longer work with McCabe, and McCabe resigned just days after finalization of the Accord.

William McChesney Martin, Jr. (April 2, 1951 to January 31, 1970): Ironically, the next central banker to infuriate Truman was the man who, as Assistant Secretary of the Treasury, actually negotiated the Accord with the Fed while Snyder was hospitalized. Perhaps best remembered for his line that "The Federal Reserve´s job is to take away the punch bowl just when the party gets going," William McChesney Martin, Jr., as Fed Chairman, repeatedly declined to intervene in the government securities markets and ignored the White House in setting monetary policy.

Alarmed by a rapid escalation in bank loans, installment credit, mortgage debt, and a surge in stock prices to a post-depression high, the Fed nudged up its discount rate from 1.75% to 2% on January 16, 1953. Martin warned banks in a speech on May 6, 1953 not to rely on the System to satisfy their seasonal need for reserves in the fall. His admonition sparked the worst crisis in the bond and money markets in 20 years, and sent the economy into a shallow downturn between July 1953 and August 1954, even though the Fed began lowering reserve requirements on July 9, 1953 in response to the bond crisis.

Arthur Burns (February 1, 1970 to January 31, 1978): The bond crisis of 1953 evidently made quite an impression on Arthur Burns, then the recently named Economic Adviser to the President. Handpicked by President-elect Nixon in December 1968 to assume the mantle at the Fed, Burns let inflation run amok in the 1970s by failing to clamp down on monetary growth. Burns first had to wait before taking over as Chairman because Martin chose to serve out his term rather than move to the Treasury at Nixon´s request. Once ensconced in the role of Fed Chairman, Burns, a self-described free market advocate, implored the Nixon administration to enact wage-price controls in August 1971, zealously argued for a government bailout of Lockheed when the Aerospace firm teetered on the brink of failure, and proposed a multi-billion dollar fund to aid struggling companies. Burns proved a political lackey when he allowed the money stock to increase at an 11% rate before the 1972 presidential election over the objections of senior governors, and again turned on the monetary spigot in late 1976 in a futile attempt to gain reappointment by ingratiating himself with the Carter administration.

At the time, there was still widespread belief in the Phillips Curve, which postulates an inverse relationship between inflation and unemployment. In 1973, Burns testified that the objective of monetary policy is "to sustain high levels of production and employment and, in the second place, not to contribute to inflationary pressures." The stagflation that became a hallmark of the 1970s largely debunked the Phillips Curve.

G. William Miller (March 8, 1978 to August 6, 1979): A former Textron CEO rather than a banker or economist, G. William Miller was seen as subservient to the Carter White House and quickly lost the confidence of financial markets. A slide to record lows in the U.S. dollar prompted the administration to implement a dollar-support program on November 1, 1978. In 1979, with inflation already pushing into double-digit range before the oil-price shock in the second half of the year, Miller rationalized his inaction by testifying, "The Federal Reserve does not consider a recession desirable."

Paul Volcker (August 6, 1979 to August 11, 1987): With the economic situation fast deteriorating, Carter was forced to do something. Dissatisfaction with Miller ran so deep that upon Volcker´s nomination the Dow Industrials rallied over 10 points (then greater than 1%), bonds rebounded in the midst of a huge bear market and gold even fell a couple of bucks. Formerly president of the New York Federal Reserve Bank, the towering Volcker (he was 6-foot-7) jolted credit markets - and stuck underwriters of a $1 billion IBM bond offering with record losses - when he orchestrated his dramatic "Saturday Night Massacre" in early October 1979. The Fed hiked its discount rate by a full 2% on the weekend. The surprise move knocked the stock market for a 10% loss in little over a month. Contrast this behavior with Greenspan´s famed reluctance to inject uncertainty into the markets.

Keynesians were by now thoroughly discredited after a decade of slowing growth and soaring prices, and monetarism ruled the roost. Nonetheless, it took interest rates well into double digits and one of the 2 worst postwar recessions in 1981-82 to convince observers that Volcker was truly serious and break the back of inflation, which crested at 13.5% in 1980.

Alan Greenspan (August 11, 1987 to January 31, 2006): After a rocky start, Greenspan shepherded the economy through the October 1987 stock market crash, 1994 Mexican Peso crisis, 1997 Asian crisis, 1998 Russian debt default and collapse of Long Term Capital Management, bursting of the dot-com bubble in 2000, and The September 11, 2001 terrorist attacks. But was he really a savior, or did he merely throw tons of liquidity at every threat and leave the underlying problems for his successor?

Even those Fed Chairmen who´ve best withstood the test of time confronted some of their most severe challenges early on. Listed below are summaries the initial hurdles faced by each, as well as how stocks reacted.

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Initial Hurdles Faced by New Fed Chairmen
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Marriner Eccles: took office March 19, 1936 during the Roosevelt Recession. The Stock Market (S&P) topped March 10, 1937 at 18.68 and hit a low on March 31, 1938 at 8.50; a 54% decline in 1 year, 21 days.

Thomas McCabe: took office June 15, 1948 during the last leg of a bear market. The Stock Market (S&P) topped June 15, 1948 at 17.06 and hit a low on June 13, 1949 at 13.55; a 21% decline in 11 months, 28 days.

William McChesney Martin, Jr: took office January 5, 1953 during the Bond market crisis. The Stock Market (S&P) topped January 5, 1953 at 26.66 and hit a low on September 14, 1953 at 22.71; a 15% decline in 8 months, 9 days.

Arthur Burns: took office February 1, 1970 during the last leg of a bear market. The Stock Market (S&P) topped March 3, 1970 at 90.23 and hit a low on May 26, 1970 at 69.29; a 23% decline in 2 months, 23 days.

G. William Miller: .took office March 8, 1978 during the Dollar crisis. The Stock Market (S&P) topped September 12, 1978 at 106.99 and hit a low on November 14, 1978 at 92.49; a 14% decline in 2 months, 2 days.

Paul Volcker: took office August 6, 1979 during the "Saturday Night Massacre". The Stock Market (S&P) topped October 5, 1979 at 111.27 and hit a low on November 7, 1979 at 99.87; a 10% decline in 1 month, 2 days.

Alan Greenspan: took office August 11, 1987 during the Stock market crash. The Stock Market (S&P) topped August 25, 1987 at 337.89 and hit a low on October 20, 1987 at 216.46; a 36% decline in 1 month, 25 days.

In the late 1920s confidence in the Federal Reserve ran high. Foreign central banks sought its advice, and investors surmised that the greater international cooperation in monetary policy that seemed on the horizon could ensure financial stability and growth. No way, it was thought, would the Fed repeat its mistakes of 1920, when it raised the discount rate from 4% to 7% in 7 months and ushered in a deflationary depression. In the 1960s, following a lengthy expansion, a belief arose that policymakers could "fine tune" the economy to meet short-term goals; such was the faith in the reliability of their tools and analysis.

Bernanke has extensively studied the Great Depression as well as the Japanese deflation and bear market of 1990-2003. He concluded that central bankers erred by targeting the red-hot stock and real estate markets leading up to both. Like his predecessor, Bernanke never met an asset bubble he didn´t like. Yet Bernanke is committed to the idea that he must seek to allay any pain that may result from such speculative excesses, hence his deflation speech.

Bernanke has seemingly inherited the best of all worlds, and appears so unwilling to deviate from Greenspan´s methods, that he´s already being called "Mr. Status Quo." By every indication, he intends to carry on traditions established by Greenspan, including the increased transparency that has characterized the Fed´s machinations in recent years. Greenspan was loath to surprise the markets.

But Bernanke is not Greenspan, and conditions have changed. Given the resurgence of '70s-style commodity inflation, Bernanke may need to serve up something unexpected, as Volcker did when he came upon the scene. If not, he risks being seen as pandering to Wall Street.

Metals markets seemed unimpressed by the inflation-fighting promise of Bernanke´s widely anticipated opening interest rate move. Gold prices closed in on $600 an ounce, and silver neared $12 for the first time in a generation. Platinum hit an all-time high, and copper topped $2.50 per pound for the first time ever. At this rate, how long before people start melting down their pre-1982 pennies?

If history is a guide, the new Fed Chairman will be tested sooner rather than later, and the perception of both Mr. Bernanke and the institution he heads will likely be radically altered by the time he leaves office.

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Complete Forecasting Service
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2006 promises to be a watershed year across all markets, including stocks, bonds, commodities and the dollar.

Prepare yourself now with over 200 years of comprehensive market data and the battle-tested methods of W.D. Gann going to http://www.gannglobal.com and checking out the Complete Forecasting Service.

About the Author: James Flanagan is a well known historical analyst in the field of financial market research and forecasting. Using a proprietary, complete database of market price history and the methods of W.D. Gann, he has been publishing his forecasts and investment research since 1990 (Past Present Futures newsletter). James oversees all of the research for the Financial, Stock, and Commodity Markets at Gann Global Financial. You can visit his website: http://www.gannglobal.com

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