“…no one knows which war the Fed is fighting.*”

Chairman Bernanke's performance yesterday may have earned him a passing grade but it was no A+ in my book.

First, kudos to the staffer for Republican congressman Jim Saxton for asking what I thought were the best questions. Probing into hedge funds, liquidity, leverage, and the economy, Bernanke’s replies were very telling.

On the downside of the Chairman’s testimony were his replies to the issue of hedge funds. In my opinion, Mr. Bernanke was way off the mark re the risks they pose. Moreover, he failed to acknowledge the interconnected nature of money. Is it realistic to believe that financial capital has no role in the real economy? Is it realistic to assume that the risks of liquidity and leverage are contained to the sub prime mortgage market only? Time will tell if his sanguine response is correct.

The upside to the Bernanke’s testimony was the Fed’s balanced approach to the risks of slow growth and inflation. Here he is right on the mark. Investors may clamor for lower short-term rates. However, excess liquidity and leverage, globalization, strong global economic growth, a weak US dollar, and rising US domestic inflation argue against cutting rates at this time.

Investment Strategy Implications

The sub prime mortgage fiasco has made clear to the Fed that unchecked liquidity and leverage has consequences. The balanced concerns of the Fed reflect the incredibly complex globalized world we live in. The narrow, self interests of some investors may support higher equity prices. But the larger, macro strategy concerns remain with the complex web of unintended consequences.

And now on to 1Q07 earnings results.

* London School of Economics professor William Buiter in his reply to Larry Summers’ Financial Times commentary “As America Falters, Policymakers Must Look Ahead”.

http://profile.typekey.com/WillemBuiter/
http://www.ft.com/comment/columnists/lawrencesummers