The announced, surprise resignation of Federal Reserve vice-chairman Donald Kohn, a Greenspan protégé, will offer an early sign of just how committed (or not) President Obama is to the Fed's inflation-fighting mission. For the moment, let's put aside any speculation over why Kohn might have resigned.
We're going to find out, sooner rather than later, whether the badly bloodied Fed chairman Ben Bernanke will have the support he may need from the White House to head off a potential stagflation threat (already taking shape in the UK), or whether his authority (such as it is) will be (further) compromised.
President Obama's selection of a replacement for Kohn and the other two empty slots on the Fed's seven-seat Board of Governors, will be a key sign of the extent to which the U.S. central bank will be bolstered or undermined in its mandate to put long-run stability ahead of short-run temptations to boost growth at long-term expense. It's already a failure on that front. The question is whether its past failure will be compounded going forward.
As I wrote in an earlier piece, the Fed faces its own "New Normal" of reduced credibility and clout amid an ongoing economic slump -- a combination that could bring its inflation-fighting credibility into serious doubt and inflation expectations to levels we haven't seen since the late 1970's:
With America's unemployment rate likely to stay in double-digits for some time, a bigger permanent American underclass in the making, economic growth poky and government-inflated at best, no clear signs over the horizon of any significant commitment to improve economic growth the old fashioned way -- to "earn it" by improving the business climate ("It's the Business Climate, Stupid") -- D.C. more widely derided than it has been in decades, and an historically debt-heavy government that will be under ever more pressure to inflate its financial problems away, the Federal Reserve is and will be under the gun in a way it hasn't been since Paul Volcker headed the Fed through the energy crisis of the late 70's and early 80's.
Actually -- the risk is greater today. Paul Volcker had the absolute backing of then-President Ronald Reagan to do what it took to keep inflation under control (including jacking up interest rates into the double digits). Also, the U.S. was in a better financial position (a debt-to-GDP ratio of 30% versus today's 100%). Volcker had bigger pro-votes in the Senate than Bernanke appears likely to get. President Obama's current support notwithstanding, Bernanke can't count on that support tomorrow when political push comes to shove. President Obama no longer has Reagan-sized level of popularity, and the President's party -- predisposed to putting short-term growth ahead of inflation control and long-term stability during the best of times -- can be expected to put more pressure on the Fed to be more loose than it would otherwise be, especially as the 2010 and 2012 elections approach.
I've recommended focusing on the spread between between U.S. Treasuries and the inflation-protected variety (TIPS) and the spread between yields on U.S. Treasuries and similarly dated German bunds as key measures of the Fed's credibility gap going forward. The core idea is to at least consider trading that gap as the signs become clearer: short long-dated Treasuries, go long on German bunds (PIMCO's leading on this one), Inflation protected Treasuries and commodity-based indices and ETFs.
As Michael Franzese of Wunderlich Securities in New York told Bloomberg earlier this month, it's troubling that the yield curve has been steepening over the past few weeks amid more signs the "recovery" has either stalled, reversed or was fraudulent to begin with:
“The steep yield curve is starting to reflect signs of stagflation...The short end will remain tied to the fed funds. Yet we are seeing inflation signs and, as a result, long-dated maturities are getting hurt.”
President Obama, through his selection of a replacement for Mr. Kohn and for the other three empty slots on the Fed's board, will give us an early sign of whether these concerns are fully justified.
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