Independence Day for the Fed

By Paul R. La Monica, editor at large


NEW YORK (CNNMoney.com) -- Interesting times lie ahead for Ben Bernanke.

The Fed chairman was confirmed by the Senate for a second go-round as el jefe of the central bank Thursday, but by the narrowest margin in history.

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It seems odd to say that a 70-30 vote in favor of Bernanke qualifies as tepid support, yet that's the way it works in Washington.

So what happens next for the Fed? If the economy is really on the road to recovery -- and Friday's strong GDP report suggests that this is the case -- then Bernanke is going to have to shift from crisis management to the more mundane, but equally important, task of managing interest rates.

It's no secret that with the central bank's key federal funds rate remaining near zero percent, the next move by the Fed will be to raise rates. But when will it start and how aggressive will it be? Let the debate begin.

The Fed is supposed to be above politics. However, the populist backlash against Bernanke and the central bank as a whole in the past year -- reflected in the "close" vote for Bernanke and last week's fears that he might not even be approved for a second term at all -- may mean that the Fed can't completely ignore the wishes of lawmakers.

An interest rate hike would not be popular. It would likely lead to higher rates for people with adjustable-rate mortgages, for example.

"The Fed's not political. You have to know that," joked Brian Battle, vice president with Performance Trust Capital Partners. a fixed-income trading firm in Chicago. "But can the Fed resist pressure to not do more if people start yelling about mortgage rates being too high?"

It could also create some jitters in the stock market and raise questions from members of Congress about whether the Fed is killing an economic rebound before it really has a chance to unfold.

With that in mind, it's reasonable to argue that the Fed may be reluctant to raise rates too soon. Hopefully though, that won't be the case.

In fact, there's an equally compelling argument that Bernanke now will be able to go about doing what he feels is best for the nation's economy without having to worry about what lawmakers think.

"Congress got to vent a bit and deflect some of their responsibility to the Fed," said Michael Materasso, senior vice president of the fixed income group with money manager Franklin Templeton. "The Fed has to stick to trying to understand economic trends and acting accordingly to manage growth and inflation. They don't have to look over their shoulder and worry about Congress judging them."

Even though Bernanke didn't win the usual near-unanimous support for another term, that doesn't matter. What matters is that he was confirmed, so he doesn't have to be subjected to another Senate vote until 2014 -- if he and whoever's president think a third term is a good idea.

"Interest rates have to rise and whenever they do it's going to be politically unpopular," said Joseph Mason, a professor of finance at Louisiana State University. "But this is the time when the chairman of the Fed should be asserting his independence. He has just been confirmed and has another four years ahead. Now is the time for him to speak out."

The case to start tightening

The Fed left interest rates alone at its meeting this week and reiterated in its statement that they should remain "exceptionally low ... for an extended period."

But one member of the Fed's policy-setting committee, Kansas City Fed president Thomas Hoenig, voted against continuing to use such language.

While that may seem like a minor quibble with semantics, this sets the stage for the central bank's Federal Open Market Committee (FOMC) to start focusing sooner, rather than later, on when to start raising rates in order to fight inflation.

"[Hoenig's] dissent signals that the argument for modifying or removing that language will likely be made at every upcoming meeting until the language is changed," wrote Barclays Capital economist Dean Maki in a report Friday. He added that he expects the Fed to start raising rates in September.

And in a speech Friday morning before the GDP numbers were released, Fed vice chairman Donald Kohn said that "it is obvious that as the economic recovery gains traction, it will be appropriate at some point for the FOMC to raise rates."

Both Kohn and Hoenig are considered to be so-called inflation hawks so their comments are not that surprising. And even though inflation is not a problem yet, some argue the only way to make sure that it doesn't become one is for the Fed to demonstrate that it won't keep rates too low for too long.

"The bond market would welcome an increase in the fed funds rate," Battle said. "There is no practical difference between rates at zero and rates at 0.5%, but it would signal that the Fed thinks the economy is really getting better and that it is reasserting its independence. That is what it needs to prove right now."

Reader comment of the week: Todd Farwell wins this week's honors with this gem in response to my rant against our nation's capital on Wednesday. "If the markets hate Washington, the markets and I finally have something in common. The only thing that Washington DC is good for anymore is Jon Stewart's ratings."

Good stuff. So keep those comments coming everybody. Finally, this will be my last nagging reminder to get your Buzz fix in 140 characters or less. Follow me @LaMonicaBuzz!

-- The opinions expressed in this commentary are solely those of Paul R. La Monica.  To top of page

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