« Why China Won't Become Super | The RCP Blog Home Page | A Tale of Two Vice Presidents »

The Bush-Bernanke Rally

Call it the Bush-Bernanke rally.

After two days of Congressional hearings, new Fed chairman Ben Bernanke delivered a “not-too-hot” and “not-too-cold” testimony that reassured financial markets, driving up share prices by roughly one percent across-the-board, while gold, bonds and the dollar were flat.

Meanwhile, for the first time, the Senate voted 53-47 this week in favor of extending President Bush’s investor tax-cuts on dividends and capital gains. Senator John McCain, who voted against these tax cuts in 2003, voted for them this week. That is important news for the GOP Presidential frontrunner.

During his hearings, Ben Bernanke gave the Bush tax cuts credit for economic recovery. Mr. Bernanke also pledged to keep basic inflation around 2 percent or less, and he narrated a positive view of the economy.

His biggest concern on the inflation front seemed to be a spillover effect from higher energy prices. But that hypothetical thought is being overtaken by events in the energy trading pits, where gasoline prices are plummeting and crude oil has dropped below the $60 dollar a barrel threshold. With energy inventories high, lower prices will pull down inflation rates in the next couple of months.

Lower gas prices at the pump are increasing the purchasing power of rising consumer incomes from steadily impressive job gains. This is what the housing pessimists are missing. Any cooling of the home real estate market and the cash-out income value from that market is being more than offset by falling unemployment and rising income from the job creation of healthy American businesses.

The best part of Bernanke’s testimony was his reference to the Wicksellian real-interest rate model, calculated through the difference between inflation indexed bonds and cash bonds. These forward-looking bond market indicators tell Bernanke that inflation worries are “well anchored,” and that the Fed’s interest rate target will move to neutrality at 4.75 percent, or more likely, 5 percent in the next couple of months.

The worst part of the Bernanke performance was his lingering references to resource utilization and “excess” economic growth above potential. Remember, in the second half of the 1990’s, unemployment dropped to 3.9 percent, while real economic growth averaged above 4 percent, without upward inflation pressures. The Fed’s aggressive over-tightening in 2000 led to a generalized deflation of commodity and equity and business investment. This was Greenspan’s biggest mistake, predicated on a short-run Phillips Curve trade-off which gave the Central Bank a very bad policy signal.

Hopefully Bernanke will stick with the bond indicators, bolstered by commodity and currency market signs, and will push the Phillips Curve into the background where it belongs. Otherwise, this old Soviet Gosplan approach to central planning will doom the recovery cycle.

Fortunately, Mr. Bernanke will be ably assisted by two new Fed board appointees--Kevin Warsh and Randall Kroszner--both of whom were unanimously approved today by the Senate Banking Committee. Full Senate confirmation will occur in due course. As I’ve been saying all along, George Bush has moved the Fed’s center of gravity toward free-market, supply-side economics.

Notably, Bernanke not only credited tax cuts for economic recovery, he also endorsed school choice and vouchers for better education performance. And he also contended that private market companies, not government, should underwrite terrorism risk insurance.

It’s safe to say that the “old guard” Fed bureaucracy--led by Donald Kohn--doesn’t like this free market assault one bit. They were the ones leaking potshots at young Kevin Warsh, (the Harvard trained lawyer, former investment banker, and senior policy advisor, who will be the only person in the Fed building with any real world financial market experience and contacts).

So, the Bernanke revolution is just beginning. No major news or radical departures were broken during his first two days in front of Congress. Stock markets are looking through the next couple of minor rate hikes toward pro-growth policies and a profitable continuance of the economic expansion.

It’s a good beginning.