Today, Bernanke and QE2

David R. Kotok
Chairman and Chief Investment Officer
Today, Bernanke and QE2
October 15, 2010


We expect an upward movement in stock prices through yearend because of the Fed’s actions. In Boston today, Ben Bernanke has clearly stated the position of the majority of the FOMC.

The target is to get inflation HIGHER and the risk is that it is too low and will be going lower. Bernanke is consistent with his history and with his research on the Great Depression era. This is the same man that I heard with my own ears when he was a professor and before he started his Fed and government career. Be clear about one thing: Ben Bernanke will not be the Fed Chairman who presides over a US economy in depression and with deflation. Not now, not ever, if he can avoid it.

The Fed’s application of new tools is without limits. It will do whatever it takes. There are dissenters on the FOMC. We hear them. But they are in the minority when it comes to the voting on actual policy.

The Chairman has the votes. The Fed mostly runs on a consensus decision-making, publicly announced policy. In the end, all the governors and the NY Fed president will vote with the chairperson. The other regional bank presidents are divided in their views. At any time, about half or more of the remaining four voting regional bank presidents will side with Bernanke. He has the votes. He wants more stimulation in whatever form he can get it. He wants inflation to reach a target of slightly under but around 2%. He needs to get the inflation rate above 2% to determine he has safely reached his goal. It is presently under 1%.

Note Bernanke’s reference to the median CPI published by the Cleveland Fed. We track this monthly and suggest readers do the same. This measure of inflation was designed some time ago by Steve Cecchetti (now at BIS) and Mike Bryan (now at the Atlanta Fed). It attempts to estimate the inflation result attributable to monetary policy as opposed to the inflation outcomes coming from shocks like energy or food.

Bernanke has just made the Cleveland Fed measure an item that will quickly leap to the top of the watched inflation indices. The Cleveland Fed will email you the release if you sign up on their website. Check the latest median CPI computation, which was just released. There is a long way to go to get inflation to a threatening place.

Bernanke has time on his side. He will hold this current position for a long time and until he sees an inflation rate north of 2%. Safety in policymaking requires him to get sustainably above his target before he takes policy to neutral. That may take years to achieve. By a long time, we mean months and years, not days and weeks.

We expect the markets to respond positively. Bonds face lower yields, since this is an outcome the Fed wishes to achieve and which the Fed has the firepower to obtain. Cumberland’s bond accounts are nearly fully invested and have long duration. We positioned high-grade Build America Bonds, as recently as yesterday, with yields above 6%. They are cheap.

Stocks are products of two inputs. They need lower interest rates, which allows the equity risk premium to be higher. Lower rates are here for a long while. In addition, stocks need the corporate ability to finance at those low interest rates. Both are in place and will be sustained for an “extended period.” Stocks also need high productivity and low labor-cost pressure. Both are in place. Our US stock market target of 1250-1300 on the S&P 500 index within a year is intact. Our ETF accounts remain fully invested, as they have been nearly all the time since the March 2009 low. It is too soon to sell your stocks. It is NOT too late to buy thoughtfully selected positions.

The Fed will maintain this approach until the employment situation improves. That means a while. Jobs are capable of slow recovery until the housing situation stabilizes. The foreclosure mess has just extended that sector’s volatility and pain for many more months. My friend Art Cashin has addressed this several times in his interviews and writings. I discussed it with him recently when we had a chance to visit together at the NYSE. Be sure: this is a mess and unscrambling these eggs will take a lot of time. It will provide employment for lawyers. The summary is that housing has a long way to go and it needs mortgage finance to achieve a turnaround. Only time and straightening out the mess will allow housing to get stable.

Lastly, and this is directed to some of my debating colleagues on CNBC and others who spend their time in wasted effort of cacophony, it is time to set aside this screaming about what SHOULD be. Take the word should out of your lexicon.

The Fed is on a track and the Fed chairperson has made it clear. We will get QE. Let’s talk about the future outcomes, not past errors. In a forthcoming piece, we will describe our expectations of the outcome of QE II.

David R. Kotok, Chairman & Chief Investment Officer, Cumberland Advisors,

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