UNITED STATES: Bernanke faces stiff challenges at Fed

Analysis

President George Bush prefers to select trusted insiders for important positions. Bernanke does not quite fit that description, but his experience over the past four months as head of the White House Council of Economic Advisors (CEA) was enough to seal the nomination. His three years as a Fed governor (2002-05) and impeccable academic credentials in monetary economics also weighed heavily in his favour. Bernanke will almost certainly be confirmed by the Senate in November and take over as Fed chairman on February 1, 2006.

Market reaction. The markets had considered Bernanke the front-runner and had few jitters about his selection. The yield on the 10-year bond rose on the day of the announcement, but only by seven basis points. By comparison, bond yields rose by 27 basis points on the day that Greenspan was nominated to replace Paul Volcker as Fed chairman in 1987.

Bernanke's qualifications. He combines a sterling academic record with experience as a policymaker. However, he has never been a financial professional and his leadership skills are untested:

1. Top economist. With his Massachusetts Institute of Technology and Harvard training, long and distinguished academic career and policymaking experience as a Fed governor and CEA chair, he is a well-respected figure.
2. Not a financier. A possible weakness is his lack of financial sector experience. He does not have first hand knowledge of how corporate executives gauge confidence, make investment and hiring decisions, or react to daily information. This is in contrast to Greenspan, who had previously served as a Wall Street economist and financial adviser. Significantly, only one other purely academic economist, Arthur Burns, has served as Fed chairman in the last sixty years.
3. Crisis management. It is unclear how well he would react in an international financial crisis, should the US government have to intervene to restore confidence in the dollar. Unlike former Treasury Secretary Robert Rubin, who drew on his experience as a Goldman Sachs executive to gauge market sentiment during the Mexican peso meltdown, Bernanke lacks such a background. Some on Wall Street will inevitably see him as an 'analyst' rather than a 'portfolio manager' -- a dismissive assessment.
4. Leadership skills. Greenspan was often able to command unanimous decisions during the Fed's Open Market Committee (FOMC) Meetings. By Bernanke's own admission, his administrative and leadership abilities are untested.

Bernanke's priorities. Upon assuming office, he will immediately seek to establish his credibility with the market. Later, he may attempt to revise the Fed's approach to monetary policy:

1. Anti-inflation credentials. His first priority will be to establish his anti-inflation credentials. Given that headline Consumer Price Index (CPI) inflation has recently jumped to 4.7%, it is possible that he may press FOMC colleagues to accelerate the Fed's current tightening cycle or extend its duration, to ensure that markets recognise his inflation-fighting priority (see INTERNATIONAL: Policy announcements fail to surprise - October 21, 2005).

2. Inflation targeting? Over the long term, Bernanke is likely to shift the Fed toward an inflation-targeting regime. This involves designating a target range for inflation, and seeking to maintain it within those limits.

   Greenspan has always opposed the creation of a specific inflation target for the US economy -- perhaps because the Fed's statutory mission involves both creating a pro-growth environment and containing inflation. Indeed, inflation targeting may unnecessarily tie the Fed's hands. The practice is most frequently used to establish the credibility of central banks in the developing world (see INTERNATIONAL: Inflation targeting yields results - October 11, 2005).

   However, it is possible that Bernanke may eventually conclude that Greenspan's decision to reject an inflation target was correct. In a July 2001 research paper, Bernanke analysed whether a monetary policy rule that he developed would be more effective than Greenspan's 1987-2000 record of fighting inflation and promoting employment growth. He concluded that while both his rule and Greenspan did equally well at fighting inflation, Greenspan's more flexible approach was better at stimulating economic growth and job creation.

Threats to growth. On the horizon, Bernanke is likely to confront two serious policy challenges that may threaten growth:

1. Asset prices. Greenspan has long insisted that monetary policymakers should not try to identify and contain asset price 'bubbles'. The current rise in housing prices is a case in point. Real estate prices have shot upward in many areas of the United States, and a bursting of the bubble could herald a major downturn for the industry, with serious implications for economy as a whole (see INTERNATIONAL: House prices complicate monetary policy - July 22, 2004). Bernanke agrees with Greenspan on this count, and is unlikely to give much weight to asset prices as he charts a course for monetary policy.

2. Dollar crisis? Managing potential financial crises will be one of Bernanke's key challenges. Although very unlikely, it is conceivable that increasing US current account deficits could precipitate a steep decline in the dollar and a crisis of confidence. In this eventuality, Bernanke enjoys two potential avenues of support:

   • New York Fed. During his first year as chairman, Greenspan relied heavily on the experienced head of the New York Fed, Jerry Corrigan, to help deal with the stock market crash of 1987. Bernanke should be able to depend on the current President of the New York Fed, Tim Geithner, a veteran of the international financial troubles in the late 1990s, for similar backing and counsel.
   • US Treasury. The Treasury Department no longer enjoys the leadership of a skilled operator like Rubin. The current Treasury crisis management team, including Secretary John Snow, lacks deep experience in international financial markets. Therefore, a potential dollar crisis, especially early in his tenure, could prove to be a major test for Bernanke.

Public influence. Greenspan's reputation eventually grew to the point where he became viewed as the unofficial US 'economist-in-chief' and was solicited for his opinion by Congress in all areas of US economic policymaking. Given Bernanke's current White House role, he is likely to avoid making broad assessments of administration policy in the medium term, to promote his independence.

Bernanke has recently made a conscious effort to inject traditional Republican rhetoric into his speeches, including extolling the virtues of tax cuts to promote economic growth. However, this was probably part of his 'campaign' for the Fed chairman's job -- he is actually a political moderate. Once he is firmly established in office, Bernanke is likely to criticise large US government budget deficits -- exercising a restraining influence on fiscal policy (see UNITED STATES: Katrina upends fiscal policy - September 20, 2005).

Likely confirmation. Unlike Harriet Miers, who yesterday withdrew her nomination for the Supreme Court, Bernanke's nomination has earned praise from both Republican and Democratic members of the Senate Banking Committee. The committee chairman, Senator Richard Shelby, has promised to give Bernanke a 'vigorous' hearing -- but the nomination is almost certain to be confirmed.