Be Careful What You Ask For . . .

David R. Kotok co-founded Cumberland Advisors in 1973 and has been its Chief Investment Officer since inception. He holds a B.S. in Economics from The Wharton School of the University of Pennsylvania, an M.S. in Organizational Dynamics from The School of Arts and Sciences at the University of Pennsylvania, and a Masters in Philosophy from the University of Pennsylvania. Mr. Kotok’s articles and financial market commentary have appeared in The New York Times, The Wall Street Journal, Barron’s, and other publications. He is a frequent contributor to CNBC programs. Mr. Kotok is also a member of the National Business Economics Issues Council (NBEIC), the National Association for Business Economics (NABE), the Philadelphia Council for Business Economics (PCBE), and the Philadelphia Financial Economists Group (PFEG).


Be Careful What You Ask For………..
July 24, 2009

Oh, Ben. Why did you offer this?

In his Q&A session at the Senate on the second day of his testimony, Federal Reserve Chairman Ben Bernanke offered a response to a question about the Fed’s role in consumer protection. He suggested that the Senator reopen “the Act” and add the consumer-protection role to the Fed’s mandate.

I cringed.

So did several others within the Federal Reserve who were in disbelief at what they heard. So did many others outside the Federal Reserve who have been championing the Fed’s independence when it comes to monetary policy. In Bernanke’s defense, he also added that any law changes must not alter the independent ability of the Fed to formulate monetary policy. Those words mean the Fed’s ability to raise interest rates when it deems it has to fight inflation.

But by inviting the Senate to open the law to changes while asking to remain independent is like putting your head in the lion’s mouth and asking the beast to be considerate. Chairman Bernanke is now engaged in a high-risk gambit.

Reopen the Federal Reserve Act?

I am now seriously worried that the Congress will take Bernanke up on his offer. Once an amendment to the Federal Reserve Act is on the table (which it is), anything may happen. Remember, this would be a bill that has to clear the Senate and the House (Pelosi, Frank, and company) and then get to a conference.

In the famous Geithner “white paper” which will receive Congressional discussion today by various witnesses including Bernanke, there is a proposed provision to give the Treasury Secretary a veto over the Fed’s use of emergency powers. Remember, the Treasury Secretary meets weekly and one-on-one with the President. What could be more political than that?

Picture a situation where there is a need for one of the Fed’s emergency actions, such as we have seen in recent months. If the Geithner proposal comes to pass, how would that work? And can we ever be assured that the policy positions of the Fed would be taken from a neutral starting place? I wonder.

Fed policy could easily become asymmetric and therefore inflation-biased. Imagine a situation where the Treasury has invested TARP funds and doesn’t want to admit losses. Isn’t it easier for them to have the Fed keep an entity alive with hope for a miracle rather than be embarrassed by a failure? Is it possible for a politician to admit an error and take a small loss rather than defer the loss, even though the final cost will be much larger? Decision-making biases are hard enough to overcome without imbedding a structure that worsens them.

Bernanke knows this. So why did he invite the Senate to reopen the Act?

Maybe his political advisors are not guiding him well. They may be telling Bernanke that this proposal will be disarming and soften the Fed’s critics. Maybe he is following a protocol of open democratic process that is a result of his academic career. Or maybe he believes the Act will be reopened anyway and it is better tactically to propose changes proactively, and try to modify the outcome, rather than resist it. No matter how one plays out this sequence, it is hard to find a good outcome. We fear the politicization of the central bank.

That said, markets are not focused on the Fed and political risk. Markets are looking only in the shorter term for Fed policy that remains highly stimulative. That means continued very low short-term interest rates are in the cards. For Treasury bonds that means retrenching (higher rates, lower prices) as the risk of an economic Armageddon subsides and as signs of a bottoming economy recur.

We continue to emphasize spread product on the bond side. Tax-free and taxable Munis offer good values in the bond turf.

Stocks have an upward bias. In the stock markets our accounts are fully invested. So far, the summer has been beneficial to clients in both fixed-income and equity asset classes. We are pleased with our ETF strategies as the stock markets of the world recover from the March lows. In the United States, we are targeting 1100 on the S&P 500 index by early next year.

David R. Kotok, Chairman and Chief Investment Officer, email:


Cumberland Advisors
614 Landis Avenue Vineland NJ 08360-8007

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