Federal Reserve Bank Chairman Ben Bernanke has come under fire early in his new job. He has acknowledged suffering a "lapse of judgment" by talking to CNBC reporter Maria Bartiromo, an episode that caused shock in the global stock market. Moreover, he looks nervous.

But Ben Bernanke is in the management business. Do we really care a whit what off-hand remarks Bernanke may have made in a social context to a journalist? And is Bartiromo really an independent and objective reporter of news? She has always appeared to us, like many of her peers at CNBC, as a cheerleader.

Call her what you will, we're not talking about a Bob Woodward here.

As observers of the U.S. economy, we care minimally how Bernanke communicates with the market, and we know his so-called "lapse of judgment" has only short-term impact on the market. However, we are worried that he may be making the wrong judgment on the U.S. economy.

The issue that confronts us is not about CNBC but about us. We the People are the market, not the CNBC media that presents images and commentary for their own reasons most of which have to do with their promoting their own brand, asserting that their TV personalities, Bartiromo, Kernan, Kudlow, Cramer et al are the center of the universe.

The Fed chairman's job is a challenging one at the best of times and these are challenging times.

As the successor of the ‘great' Greenspan, Bernanke was initially worthy of sympathy considering the huge pressure he took on.

The current economic situation is complicated indeed. David Wessel of Wall Street Journal has observed,

"The dollar is sinking. Global stock markets are volatile. Bond-market interest rates are climbing. Oil prices are up. Gold is at a quarter-century high. Housing prices are softening. Protectionist pressures are intensifying. General Motors Corp. is a candidate for bankruptcy court. Iran may be on the verge of going nuclear. A nasty, partisan congressional election looms. And a new Federal Reserve chairman's inflation-fighting resolve is being tested."

What's more important to us at this point in time are the discordant messages sent by the U.S. economy itself.

On the one hand, Americans worry about high and rising costs and fully utilized industrial capacity. These factors may lead to future pressure on inflation.

On the other hand, the U.S. economy has already entered the late phase of this business expansion cycle. The momentum of the growth in the five years following 9/11 is fading. The rising of the short and long term interest rates, the stagnancy of corporate investment, the deceleration of productivity and the slack of the real estate market; all of these driving forces might in the aggregate cause a sudden breach of the U.S. economy.

Since the Fed interest hike on May 10, the global stock market has sunk by 10.8 percent; trillions of dollars vaporized in just a month. And a careful assessment of the S&P Global 1200 data (through June 12, 2006), which includes the U.S.-based S&P 500 data, shows that capital is being withdrawn much more quickly in foreign markets.

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Meanwhile, traders have become carping critics of Bernanke's remarks.

But, what does the sharp sell-off of the international equity markets this month tell us? Isn't that the communication we should be focused on?

Bernanke might have misjudged the economic situation.

We believe that what traders are worried about is not the inflation pressure in the world today but the misplay by the U.S. Federal Reserve Bank on the inflation issue.

A fundamental fact that we feel has not caught enough public attention and perhaps the attention of the Fed is that thanks to economic globalization and the maturation of China and India, the over-infused liquidity that has beset the world since 9/11 has been, to a great extent, converted into the bulge of the global asset base rather than inflation in the advanced economies of North America and Western Europe.

Failing to incorporate globalization into consideration, traditional indicators of the U.S. economy have served to aggrandize the inflation pressure. Meanwhile, it is our view that the focus should be on the growth rate of the American economy, which we believe will be sharply lower in the coming quarters.

And that is with no further change to Fed policy.

With reduced levels of foreign capital investment going into emerging economies that rely heavily on export, and with less demand for exports to America, it is hard to estimate how bad the deceleration of the U.S. economy would impact on these new economies. It could be horrific.

That is the quandary that traders face today.

Undoubtedly, without sustainable growth in capital investment, and with declining foreign demand, the emerging economies will have to reduce their maniac demand for commodities and raw materials. That shoe has already dropped in the global futures market.

Moreover, the prices of their exports will drop sharply. As a consequence, the inflation pressure of the U.S. Producer Price Index will be lowered significantly from the middle of this year.

The conclusion we draw from the RiskFile econometric model is that the growth rate of the PPI will actually turn negative in November " not increase as traders believe today.

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The growth rate of the production price index is expected to descend steadily. (Data source: FRED and BLS, U.S. Dept of Labor. Model prediction: RiskFile)

Such a decline in PPI would be very helpful in stabilizing the U.S. consumer prices.

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The growth rate of the consumer price index will likely moderate significantly and maintain at the current level or even decline. (Data source: FRED and BLS, U.S. Dept of Labor. Model prediction: RiskFile)

Wall Street economists appear to have reached a consensus that the U.S. economy, as measured by Gross Domestic Product (GDP), will decline over the next two quarters to an annual growth rate of about 2.5 percent.

According to the RiskFile model, the deceleration of the economy might be more serious than most economists expect. Prior to the release of the June 13 and 14 PPI and CPI data, here is the model projection for U.S. Industrial Production. (Note: the RiskFile Model uses the monthly Industrial Production data which is highly correlated to GDP. Unfortunately, GDP data is produced quarterly.)

While not going into recession, we believe that the U.S. Industrial Production will fall to a level of just over +1.0 pct in 1Q07.

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The growth rate of U.S. industrial product is forecast to decrease significantly from 3Q06. (Data source: FRED and BLS, U.S. Dept of Labor. Model prediction: RiskFile)

If the Fed continues its aggressive interest hiking policy, the consequential descent of U.S. economic growth would be the most significant global event of 2006 " not the present sell-off in the metals as you may be thinking.

The key point then is that the RiskFile Model is indicating that traders ought to be concerned more about the possibility of economic slowdown than the one that inflation will get out of control.

Possibility of the Replay of International Economic Crises, Only Worse

If the U.S. industrial growth rate declines to our predicted rate of +1.2 percent in 1H07, the negative impact on global equity markets will be more serious than expected.

The global equity market, as seen by the S&P 1200 index, is obviously giving an opinion that such weakness in the U.S. economy will materially hurt the emerging economies " not just the commodity producers like Russia and Brazil but the commodity consumer nations like India.

Moreover the major trade export nations that traditionally profit from a strong U.S. economy, like Japan and South Korea, are facing equity markets in sharp decline as well.

In the recent years, the new high-growth economies, represented by China and India, have been developing in a pattern similar to the economies of the Four Asia Tigers (South Korea, Taiwan, Hong Kong and Singapore) in the 1990s. Their development is highly relied on export; their capital markets are inflated because of the global abundance of capital liquidity.

Evidence that the U.S. economy is losing traction will show up in the Personal Consumption Expenditure data. The following chart shows that U.S. consumers have moderated their purchases starting in January 2006.

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Should the U.S. economy lose traction sharply in 2H06, the impact on the international economies would be much greater than felt by consumers in the U.S. economy itself. Traders everywhere might withdraw capital from the global market in panic.

The U.S. dollar might strengthen, but the foreign exchange market will be turbulent. At that time, short-term market interest rates will likely decline under the pressure of growing pessimism for the economy and the Fed might have to follow along with cuts in the Fed rate -- or else domestic U.S. banks, particularly the small local banks and the regional savings and loan companies, will face a financial crisis.

But the problem is bigger than a few thousand small U.S. banks; if the Fed insists on hiking the interest rate, the U.S. and the world economy might soon be facing a dangerous brink similar to the East Asia Financial Crisis of 1997. The economies from China and India to South East Asia and Latin America would be mauled heavily in the first wave of a global financial crisis.

According to the RiskFile econometric model, the current U.S. economic situation is about 90 percent correlated to the economy in 1997, and the proportion is the highest since 1997.

Based on our analysis, it's easy to understand the turbulence of the global stock market in the past month since the May 10 FOMC decision.

To a certain extent, this turbulence was probably the rehearsal of a larger turbulence to come.

What is occurring in international capital markets is surely not "the worry from the market about inflation" explained by Bernanke --- by contrast, traders are worried that the Fed's policy would put the whole world economy over the precipice.

We are entering into the most eventful time in the market since 1999's preparation for the new millennium (Y2K) and the subsequent downside of monetary expansion prior to the Bear Market of 2000-2002.

The play has begun.

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Notes:

Edward Liu co-authored this paper. He is a PhD Candidate in Economics at Peking University (Beijing), where he holds a Masters of Economics (1993). He was awarded the CFA Level designation June 2005. He served as Research Director, Capital & Finance Research Institute " Chengdu, China (1993-1995), and CEO, Chengdu China West Investment Co. " Chengdu, China (1995-2000). In Canada he became chief editor of a large Chinese newspaper and website company (2000-2004), and in February 2004, started his own Vancouver BC-based company, RiskFile Investment Research, where he is a specialist in econometrics. He can be contacted at Edward@riskfile.com

This paper was researched and translated by Ms. Hua Liang for use by media in China. Ms. Hua Liang, who holds an MBA (Finance) from Simon Fraser University, Vancouver B.C., has recently written the CFA II test.

In future months, additional analysis using the RiskFile Model will be used as a basis for some commentaries in the Bill Cara blog. Edward H.Y. Liu and I plan to collaborate on other papers like this one plus one we did on "Chinese Yuan Revaluation - Not a Wise Move" (June 6, 2005)