That’s what David Rubenstein, co-founder of the Carlyle Group, asked Federal Reserve Chairman Ben Bernanke at a Council on Foreign Relations event today.

Washington Nationals third baseman Jose Castillo does his impression of the economy. (Associated Press)

Bernanke’s reply: “Well, my forecasting record on this recession is about the same as the win-loss record of the Washington Nationals.”

The Nationals’ season-ticket-holder elaborated: The recession “surprised us in being more severe than anticipated,” he added. So the answer to Rubenstein’s question “depends critically on our ability to get the banking system and the financial system more broadly, not necessarily back to 2005, but back to a situation where…the markets are reasonably stable, and they… can perform their critical function of providing credit to the economy.

“If we can do that,” he said, “then I think that there’s a good chance that the recession will end later this year and that 2010 will be a period of growth.”

The Nationals’ win-loss record for last season? 59 wins, 102 losses. –David Wessel

Warren Buffett’s annual letter to shareholders offers plenty of investing insight, and we encourage you to follow our colleagues at WSJ.com as they dissect it. At Real Time Economics, we take particular interest in Mr. Buffett’s view of the economy and government policy.

Buffet has insight into the economy. (Associated Press)

It’s hardly shocking that Mr. Buffett would believe the economy, gripped by fear, “will be in shambles throughout 2009.” What he tacked onto that assessment — “and, for that matter, probably well beyond” — is troubling for the lack of any near-term optimism. But it’s also not a surprise. (The great investor notes that his assessment of the economy “does not tell us whether the stock market will rise or fall.” Some of his readers might hope for the market to just remain flat for now.)

Mr. Buffett at times praises the Federal Reserve and other wings of the U.S. government for their response to the crisis. In a discussion of the derivatives “time bomb,” for instance, he supports Tim Geithner — “then the able president of the New York Fed” — for preventing Bear Stearns’s failure and avoiding a financial collapse by chain reaction. “In my opinion, the Fed was right to do so,” Mr. Buffett says.

But his assessment of what the central bank response will create over the long term — a likely “onslaught of inflation” — may cause some heartburn in the months ahead for Fed Chairman Ben Bernanke and other officials who are trying to argue they can withdraw their many programs when they need to. While Mr. Buffett clearly backs most of the government response, he doesn’t think the exit will be easy.

Here’s Mr. Buffett’s precise wording in full:

“This debilitating spiral has spurred our government to take massive action. In poker terms, the Treasury and the Fed have gone ‘all in.’ Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once-unthinkable dosages will almost certainly bring on unwelcome aftereffects. Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation.

“Moreover, major industries have become dependent on Federal assistance, and they will be followed by cities and states bearing mind-boggling requests. Weaning these entities from the public teat will be a political challenge. They won’t leave willingly. Whatever the downsides may be, strong and immediate action by government was essential last year if the financial system was to avoid a total breakdown. Had that occurred, the consequences for every area of our economy would have been cataclysmic. Like it or not, the inhabitants of Wall Street, Main Street and the various Side Streets of America were all in the same boat.”

Mr. Buffett is quick to note that “our country has faced far worse travails in the past” with a dozen panics and recessions in the 20th century, “virulent inflation” in 1980 and, of course, the Great Depression in the 1930s.

“Without fail, however, we’ve overcome them,” he writes. “In the face of those obstacles – and many others – the real standard of living for Americans improved nearly seven-fold during the 1900s, while the Dow Jones Industrials rose from 66 to 11,497. Compare the record of this period with the dozens of centuries during which humans secured only tiny gains, if any, in how they lived. Though the path has not been smooth, our economic system has worked extraordinarily well over time. It has unleashed human potential as no other system has, and it will continue to do so. America’s best days lie ahead.”

Among the many other notable points in the letter:

* On homeownership, Mr. Buffett says the housing mess teaches that home purchases should require “an honest-to-God down payment of at least 10% and monthly payments that can be comfortably handled by the borrower’s income.” That income must be verified, of course. “Putting people into homes, though a desirable goal, shouldn’t be our country’s primary objective. Keeping them in their homes should be the ambition.”

* He says the lending operation of Clayton Homes, the largest player in the manufactured-home industry, is being threatened by having to compete with funders that have worse credit than Berkshire Hathaway. Firms that are backed by government guarantees — banks with FDIC support, issuers of commercial paper backed by the Fed, and others getting themselves under the government umbrella — have “minimal” money costs, Mr. Buffett says. Highly-rated firms such as AAA-rated Berkshire face record borrowing costs in relation to Treasury rates. At the same time, funds are “abundant” for government-backed borrowers but “scarce” for others. “This unprecedented ’spread’ in the cost of money makes it unprofitable for any lender who doesn’t enjoy government-guaranteed funds to go up against those with a favored status,” he writes. “Government is determining the ‘haves’ and ‘have-nots.’”

* We’re now in a world of overpricing risk rather than underpricing it, pushing yields up for municipal or corporate bonds and knocking them down to near zero for short-term government bonds “and no better than a pittance” for long-term government securities. “When the financial history of this decade is written, it will surely speak of the Internet bubble of the late 1990s and the housing bubble of the early 2000s. But the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary. Clinging to cash equivalents or long-term government bonds at present yields is almost certainly a terrible policy if continued for long.”

* Mr. Buffett rails against derivatives, which increased risks to the financial system and “made it almost impossible” to understand the largest commercial and investment banks. He devotes considerable attention to knocking Fannie Mae and Freddie Mac and how derivatives allowed the mortgage giants to misstate earnings for years. He takes repeated jabs at their regulator, then the Office of Federal Housing Enterprise Oversight (now the Federal Housing Finance Agency), for taking so long to recognize the problems at the firms.

* And we can’t leave you without sharing Mr. Buffett’s description of the troubles entailed in settling derivatives contracts. Settlements can take years or decades — while stocks take just three days — and the lengthy periods build up counterparty risk.

Mr. Buffett writes: “Participants seeking to dodge troubles face the same problem as someone seeking to avoid venereal disease: It’s not just whom you sleep with, but also whom they are sleeping with. Sleeping around, to continue our metaphor, can actually be useful for large derivatives dealers because it assures them government aid if trouble hits. In other words, only companies having problems that can infect the entire neighborhood – I won’t mention names – are certain to become a concern of the state (an outcome, I’m sad to say, that is proper). From this irritating reality comes The First Law of Corporate Survival for ambitious CEOs who pile on leverage and run large and unfathomable derivatives books: Modest incompetence simply won’t do; it’s mindboggling screw-ups that are required.”

You can read the full letter here.

– Sudeep Reddy

A roundup of economic news from around the Web.

Compiled by Phil Izzo

Talk about nationalizing some of the nation’s biggest banks is all the rage these days. Shares of major financial institutions tumbled further Friday as the chatter continued. The White House’s statement of support for private ownership — “a privately held banking system regulated by the government is what this country should have,” Obama’s spokesman put it — helped a bit, but not enough.

The government taking over a bank presents plenty of problems. Among the challenges, Federal Reserve Chairman Ben Bernanke said this week, is “that you tend to lose the franchise value, that the counterparties and others don’t want to deal with you because they don’t know your future.”

But if it’s necessary, how should it be done? Sweden is often seen as a model of bank nationalization that worked following its boom in real estate and consumer debt. Of course, the concept is always easier when you only have a few banks to worry about, rather than the 8,400 in the U.S. to sort through. (The count is 25 if you just consider the giant banks to probe, as U.S. regulators are preparing to do now.)

The Federal Reserve Bank of Cleveland has assessed the Swedish experience, in a 2007 paper and a commentary this month by two of the bank’s economists.

“Most of the criticisms that can be leveled at the Swedish crisis resolution are easy to make in hindsight,” write researchers O. Emre Ergungor and Kent Cherny. “Facing the prospect of imminent systemic collapse, incentive-skewing actions like blanket guarantees and liquidity provision can seem like surefire ways to restore confidence and avoid meltdown.”

(Blanket guarantees? Extensive liquidity provision? “Oops,” the American people might say after the U.S. government’s moves on that front last fall.)

The Cleveland Fed staffers, in a commentary this month, walk through the Swedish experience of the early 1990s and cite four key principles necessary in resolving troubled financial institutions:

1. Transparency. Fully disclosing banks’ losses “clears the uncertainty surrounding the institutions and makes it possible for the viable institutions to raise new funds.”

For the U.S., of course, the extent of banks’ losses is the big mystery. The government at least appears headed down that road, for its own analysis, by starting stress-testing of major banks to assess how they would fare in a weakening economy.

2. Political and financial independence. “If a government agency holds the purse strings, it can dictate policy and can also impede the process if emergency funding is needed,” they write.

Here, escaping political involvement entirely is a lost cause at this point. The Federal Reserve — an independent agency — oversees the major banks and is intimately involved, but the Obama administration is running the show

3. Maintenance of market discipline Investors must pay the price for missing signs of trouble, they say. “As past historical examples demonstrate, the stability of financial markets after crises largely depends on the incentive framework that is left in place.”

This is where the “blanket guarantees of uninsured depositors” comes into play to skew market discipline. It’s a form of the moral hazard argument — one that’s very much being discussed amid the U.S. response, though moral hazard of course has taken a back seat at times.

4. Restoration of credit flows Getting credit moving through the economy again, they acknowledge, is “a difficult task, given that the economic fallout from a crisis (such as rising unemployment) actually erodes credit quality further.”

With all the talk in Washington about getting banks to lend, that problem surely will stay front and center. But it’s likely to take years to work out.

Read the Cleveland Fed’s full commentary here. — Sudeep Reddy

The rising threat of deflation in the U.S. economy means the central bank needs to take unambiguous steps to counter expectations of falling prices, a central bank official said Tuesday.

“We face some risk – at this point only a risk – of sustained deflation,” in an environment where core inflation is already running “at zero to slightly negative rates,” Federal Reserve Bank of St. Louis President James Bullard said.

Because an environment of falling prices is undesirable, “one important near term goal of monetary policy is to guide the economy away from this outcome,” Bullard said.

The official’s comments came from the text of a speech delivered before a meeting of the New York Association for Business Economics in New York. Bullard is not currently a voting member of the interest rate setting Federal Open Market Committee. When the FOMC last met it kept rates at effectively zero as members continued to fret over a troubled economic outlook, along with inflationary pressures that may have weakened too much.

But as important as monetary policy is, it’s the Fed’s emergency lending policies that are now key. Last week Fed Chairman Ben Bernanke said programs that are lending to a wide array of firms and intervening directly in troubled security markets are having a positive effect.

That said, Bernanke and other officials do not see any imminent recovery in the economy, and reckon that when growth returns in the second half of the year it will likely be tame. In his speech, Bullard shared the downbeat economic outlook.

But he focused most heavily on the things Fed policy can do to counter what could be an environment of falling prices. Bullard believes the Fed needs to work harder to push back against the rising tide of deflation, and suggest how that can be done.

“The Fed needs a more systematic method of keeping the persistent component of monetary base growth rates elevated in order to combat the risk of a deflationary trap,” Bullard said. Current Fed programs are helpful in aiding markets and the economy, but “we remain far from the systematic approach I would like to see.”

Against the wide range of programs that are essentially temporary, Bullard said the best tool to signal the Fed’s intention to counter deflationary forces is its purchases of agency and mortgage debt. These purchases are well suited to serve as “the persistent component of the increase in the monetary base.” The official acknowledged the Fed’s balance sheet had grown at a very fast rate but said that the transitory nature of the programs fueling its rise keep that development from being inflationary.

Bullard also said a more systematic approach to countering deflation would entail more communication about what the Fed is trying to accomplish. He suggested setting “quantitative targets for monetary policy, beginning with the growth rate of the monetary base.”

“By expanding the monetary base at an appropriate rate, the FOMC [the Fed's policy-making Federal Open Market Committee] can signal that it intends to avoid the risk of further deflation and the possibility of a deflation trap,” Bullard said.

In his comments on the economy, Bullard said “macroeconomic expectations are very fluid and volatile.” He added “the current recession is a global phenomenon” and “it seems likely that output and employment will continue to shrink in the first half of 2009.”

“There is a risk that core prices may continue to stagnate or decline slightly for some time to come,” Bullard said. He added central bankers around the world have approached the crisis “aggressively” and “we are entering an extend period of exceptionally low policy rates globally.” – Michael S. Derby

A proposed law to amend Iceland’s central bank management will likely come into effect in a few weeks, said Kristjan Kristjansson, a spokesman at the Iceland Prime Minister’s Office.

Bernanke

“It could be a week, or two weeks,” said Kristjansson Monday.

Iceland’s new Prime Minister Johanna Sigurdardottir has asked the central bank’s board of governors, headed by board Chairman David Oddsson, to resign as she works to restore confidence in Iceland after the country fell into crisis in autumn.

She also last week proposed a bill altering the management structure of the central bank, which includes reducing the number of governors to one from three, and which creates minimum requirements for that one governor, at the very least, to have a master’s degree in economics.

Oddsson, who is a trained lawyer and whose appointment to the post was widely seen as political in nature, Sunday said in a letter to Sigurdardottir that he refused to step down.

Kristjansson said Oddsson can legally stay in power until the new legislation takes effect.

In the U.S., Ben Bernanke’s term as Federal Reserve chairman expires January 2010. Larry Summers, the economist serving as head of Obama’s National Economic Council, is widely seen as aspiring to succeed him at the Fed. –Joel Sherwood

A roundup of economic news from around the Web.

Compiled by Phil Izzo

After being dormant for many months, inflation targeting is back as a serious option at the Federal Reserve.

Ironically, now it’s the risk of outright price declines known as deflation, and not avoiding rapid inflation, that has given new momentum to advocates.

“The argument for inflation targeting now is much easier to make” with the U.S. facing a “massive deflationary shock,” said former Fed governor Frederic Mishkin, who left the Fed four months ago to return to Columbia University.

Mishkin and Fed Chairman Ben Bernanke have championed inflation targets as a way to anchor expectations and provide for better economic outcomes. But momentum for the Fed adopting targets was thwarted in 2007 first by Congressional opposition and then the financial crisis.

Mishkin isn’t alone in still seeing their merits. In the minutes of the Dec. 16 FOMC meeting, released Tuesday, officials discussed as a potential communications tool “a more explicit indication of their views on what longer-run rate of inflation would best promote their goals of maximum employment and price stability.”

“The added clarity in that regard might help forestall the development of expectations that inflation would decline below desired levels, and hence keep real interest rates low and support aggregate demand,” according to the minutes.

In other words, a commitment to an inflation target, say annual growth of 1.5% to 2%, would help keep prices from falling outright and prevent the kind of economic chaos that plagued Japan in the 1990s and the U.S. during the Great Depression.

“The key issue here is the management of expectations,” said Mishkin, who co-wrote a book on inflation targeting with Bernanke when both were academics a decade ago. “It’s just as disastrous if inflation expectations get unanchored in the negative direction…this is exactly what happened in Japan.”

Until recently inflation targeting was largely seen the opposite way — as an anti-inflation tool. And Congress, particularly House Financial Services Committee Chairman Barney Frank (D., Mass.), never warmed to the idea, since inflation targets in that context suggested tighter monetary policy and, critics said, an elevation of price stability over full employment as the Fed’s primary objective.

The Fed ultimately scrapped official targets and instead in late 2007 extended their inflation forecast horizon from two to three years and seemed to encourage financial markets to view that third year as a de facto objective.

But it never really stuck, and in their latest set of economic forecasts in late October, officials admitted their 2011 inflation forecast of 1.4% to 1.7% might be a “bit below” their assessment of what’s consistent with price stability and maximum employment.

“The horizon is not long enough” to substitute for a target, Mishkin said.

Of course, by late 2007 the very notion of debating inflation targets seemed like a luxury as the Fed shifted gears to address collapsing housing and credit markets.

But the question remains: do inflation targets, which are used by many other central banks including the European Central Bank (where deflation seems less of a risk), make sense for the Fed?

Vincent Reinhart, who headed the Fed’s monetary affairs division during the early days of the debate in 2006 and 2007, thinks they might. “It’s gone from theory to a useful governing device,” he said.

Reinhart explained that Bernanke faces two problems now that the Fed has effectively shifted from interest rates to quantitative easing as a means to stimulate the economy: communication and governance. The former involves how to explain the purpose of the Fed’s myriad credit programs and resulting expansion of bank reserves. The latter involves the division of responsibilities between the Washington-based Fed Board and the Federal Open Market Committee that includes regional bank presidents.

Inflation targets address both.

When official interest rates are as near zero as they are now, the Fed can’t offset deflationary forces with interest rate cuts to keep inflation-adjusted private borrowing costs down. But an inflation target would convey to the public that officials will use other means, like the Fed’s balance sheet, to prevent prices from falling and also keep inflation expectations from falling too low.

A target might also ease concerns that expansionary fiscal and monetary policy now will sow the seeds of an inflationary outbreak later, and would provide officials a framework with which to eventually unwind their credit programs and rate reductions.

Targets might also head off any friction between the Board of Governors and FOMC. According to Tuesday’s minutes, a “few” FOMC participants wanted the Fed to consider reserve targets to better coordinate between the Board — which sets new lending facilities — and the FOMC, which controls open market operations.

And the Fed can move quickly if it wants. “The Fed could announce (an inflation target) as part of the evolution of the communications strategy,” that Bernanke unveiled in November 2007, Mishkin said.

Officials would have a couple of options. They could simply extend the forecast horizon even further to a fourth or fifth year, in order to make it more clear to the public that their forecast range represents a long-term target. Or they could announce a more explicit FOMC-determined objective.

A challenge for the Fed would be whether to explicitly tie policy, whether via interest rates or quantitative easing, to that target or simply leave it as a forecast that may or may not be achieved.

Mishkin doesn’t regret not sticking around the Fed for this inflation target go-around, even if the odds of success seem higher than we he was a policymaker. “From a personal viewpoint, you can’t get depressed when you have ideas and they don’t get implemented,” Mishkin said. “Ideas take a long time to have an impact,” and “when the right time is there, those ideas can be very powerful.”

And even if it’s for reasons no one would have imagined a few months ago, inflation targeting’s time may be now.

“I don’t see the dynamics [of the inflation targeting debate] being fundamentally different,” Reinhart said, but “there’s a tactical reason to do it right now, and sometimes tactics dominate.” –Brian Blackstone

U.S. Federal Reserve Chairman Ben Bernanke on Thursday urged the government to consider sweeping steps to prevent foreclosures, including buying risky mortgages and refinancing them under more favorable terms to homeowners.

Bernanke

“Despite good-faith efforts by both the private and public sectors, the foreclosure rate remains too high, with adverse consequences for both those directly involved and for the broader economy,” Bernanke said in prepared remarks to a Fed housing conference. “More needs to be done,” he said.

Bernanke estimated that lenders are on track to initiate 2.25 million foreclosure proceedings this year, more than double the rate before the crisis. He also cited estimates showing as many as 15% to 20% mortgages may be “under water,” meaning more is owed on the house than it is worth.

And the housing crisis has “become inextricably intertwined with broader financial and economic developments,” Bernanke said.

Housing weakness has been a drag on the overall economy, he explained, while “a slowing economy has in turn reduced the demand for houses, implying a further weakening in the mortgage and housing markets.”

To stem that feedback loop, the Fed has already lowered official interest rates sharply. The target federal funds rate sits at just 1%, and officials are widely expected to lower that rate by at least another 0.5 percentage point when it meets Dec. 15-16, bringing the fed funds rate down to levels not seen in a half-century.

“To the extent that more accommodative monetary policies make credit conditions easier and incomes higher than they otherwise would have been, they support the housing market,” he said.

Bernanke also outlined a series of additional steps the government can take. One would be to increase participation in the Hope For Homeowners program, which puts delinquent borrowers into new Federal Housing Administration-insured mortgages.

To bring down the rate borrowers pay under that program, Treasury could purchase Ginnie Mae securities that are tied to interest rates that borrowers pay, Bernanke said. “Alternatively, Congress could decide to subsidize the rate,” Bernanke said.

Bernanke also said a “promising proposal” would be for the government to “purchase delinquent or at-risk mortgages in bulk and then refinance them into the (Hope for Homeowners) or another FHA program.” –Brian Blackstone

The prepared remarks of Fed Chairman Ben Bernanke in Austin, Texas, at the Greater Austin Chamber of Commerce.

It is a privilege for me to be here in Texas, and I would like to thank the Austin Chamber for hosting this luncheon. The Texas economy is strong and diversified, accounting for more than a trillion dollars of output last year. However, our nation, and Texas too, is being tested by economic and financial challenges. Those challenges and the Federal Reserve’s policy responses are the topic of my remarks today.

Federal Reserve Policies During the Crisis

As you know, this extraordinary period of financial turbulence is now well into its second year. Triggered by the contraction of the U.S. housing market that began in 2006 and the associated rise in delinquencies on subprime mortgages, the crisis has become global and is now affecting a wide range of financial institutions, asset classes, and markets. Constraints on credit availability and slumping asset values have in turn helped to generate a substantial slowing in economic activity.

The Federal Reserve’s strategy for dealing with the financial crisis and its economic consequences has had three components. First, to offset to the extent possible the effects of the crisis on credit conditions and the broader economy, the Federal Open Market Committee (FOMC) has aggressively eased monetary policy. The easing campaign began in September 2007, shortly after the turbulence began, with a cut of 50 basis points in the target for the federal funds rate. The cumulative reductions in the target rate reached 100 basis points–that is, a full percentage point–by the end of 2007. As indications of economic weakness proliferated, the Committee continued to respond, reducing the target rate by an additional 225 basis points by the spring of this year. By way of historical comparison, this policy response stands out as exceptionally rapid and proactive. In taking these actions, we aimed not only to cushion the direct effects of the financial turbulence on the economy, but also to reduce the risk of a so-called adverse feedback loop in which economic weakness exacerbates financial stress, which, in turn, leads to further economic damage. Unfortunately, despite the support provided by monetary policy, the intensification of the financial turbulence this fall has led to a further deterioration in the economic outlook. The Committee again responded by cutting the target for the federal funds rate an additional 100 basis points in October. Half of that reduction came as part of an unprecedented coordinated interest rate cut by six major central banks on October 8.