Greenspan out, Bernanke in

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President Bush has nominated Ben Bernanke to replace Alan Greenspan as Chairman of the Federal Reserve – arguably the most powerful financial figure in the world. What are the implications?

Federal Reserve Chairman

President Bush has nominated Ben Bernanke to be the next Chairman of the Federal Reserve, taking over from Alan Greenspan in February 2006. Mr Bernanke is currently Chairman of President Bush’s Council of Economic Advisers and before that was a Federal Reserve Board governor. Although his current role means he has close ties with the present Administration, this is unlikely to be a controversial choice and Mr Bernanke’s appointment should be confirmed by the US Senate without much trouble.

The Chairman of the Federal Reserve is important because he chairs the Federal Open Markets Committee (FOMC), the body that sets US interest rates. And US interest rates are important because they represent the price of money in the largest economy in the world (they also influence the price of money in many other economies too). It is no exaggeration to say that if the FOMC sets rates too high, it could produce a global recession, and if it sets them too low, it could allow global inflation to reawaken.

During his 18 years as Chairman, Mr Greenspan has dominated the FOMC to the point where his views are judged far more important than those of the other members. Especially in times of crisis, Mr Greenspan got what he wanted in the way of US interest rate policy. It remains to be seen if Mr Bernanke will dominate the FOMC in quite the same way.

Mr Bernanke’s views

What we know about Mr Bernanke’s views comes mainly from his academic record and his time as a Federal Reserve Governor.

Mr Bernanke’s academic reputation is based on his work on the Great Depression of the 1930s. This does seem to have left him with a fear of the implications of deflation, in particular the ineffectiveness of interest rate policy when rates are at extremely low levels. So in 2003, when US inflation was very low and there did appear to be a risk of deflation (albeit a small one), Mr Bernanke was prepared to speculate about the possibility of the Federal Reserve implementing unorthodox monetary policy measures, such as buying government bonds.

This does not mean that he will be any less hawkish than Mr Greenspan when it comes to worrying about rising inflation. A fear of deflation can be combined with an equal fear of inflation.

One way in which Mr Bernanke differs from Mr Greenspan is that he has expressed support for formal inflation targets. One consequence of Mr Bernanke’s succession may be the adoption by the FOMC of an “official” inflation target.

Although it is purely speculation at present, this might take the form of a central target rate of under 2% for a measure of core inflation (likely to be based on the consumer spending deflator excluding food and energy), with an acceptable band of 1 to 2½% (i.e. something very similar to the current target band in the UK).US inflation has been contained in such a range for the last twelve years.

In other respects, Mr Bernanke’s views are very similar to those of Mr Greenspan. In particular, both men believe that containing inflation expectations is crucial to the containment of inflation itself. The FOMC under Mr Bernanke is, therefore, likely to continue to worry about the impact of higher energy prices on inflation expectations in coming months.

What is less clear is how Mr Bernanke regards the recent strength in the US housing market. In the past he has emphasised the fundamental factors that could justify strongly rising house prices – as has Mr Greenspan. But more recently Mr Greenspan has been speculating about the possibility that the strength in the housing market is causing distortions in the US economy – for example by allowing a high level of mortgage equity withdrawal that has boosted consumer spending. We shall have to wait and see whether Mr Bernanke shares these concerns – and whether he feels there is a role for monetary policy in tackling them.

Outlook for US interest rates

Mr Bernanke’s appointment does very little to change the short-term outlook for US interest rates. We have long believed that rates would reach 4¼% by the end of 2005 (implying 25bp rate hikes at the two remaining FOMC meetings this year). That is still our view.

There could also be further rate hikes in 2006. Many judge the neutral rate of interest in the US to be about 4½%. The FOMC may raise interest rates to that level at its meeting on January 31st – the last to be chaired by Mr Greenspan. Barring any unexpected developments, Mr Bernanke would then be able to leave rates unchanged at his first few meetings in charge, arguing that policy accommodation had been removed and that it was appropriate to wait and see the effect on the economy before taking any further action.

Of course, there could well be unexpected developments. Mr Greenspan had to deal with the October 1987 stock market crash within two months of taking over the Chairmanship of the Federal Reserve, as well as the collapse of the Long-Term Capital Management hedge fund, the bursting of the TMT bubble and subsequent corporate scandals. And this highlights what is perhaps the key difference between Mr Greenspan and his successor. Mr Greenspan had years of experience of financial markets before he became Chairman of the Federal Reserve; Mr Bernanke’s background is much more academic.

Impact on financial markets

On the day that Mr Bernanke’s nomination was announced US stock prices rose and bond prices fell (yields increased). This could be seen as the markets taking a view that he might be less hawkish when fighting inflation (presumably because of his known fears of the effects of deflation). Such a reaction is probably wrong. It is always dangerous to attribute market developments to one cause (and always tempting for US-centric markets to seek that cause in the US).

In actual fact, the differences between interest rate policy under Mr Bernanke and under Mr Greenspan may be very small – and certainly rather smaller than the average error of US economists and market strategists when forecasting interest rates twelve months from now. This appointment, therefore, probably has little immediate implication for equity or bond valuations.

It may have more importance when the next “crisis” occurs. Mr Greenspan negotiated his way through several crises; Mr Bernanke is untested. It will be reasonable for financial markets to apply a bigger risk premium to financial assets at the time of the first crisis under Mr Bernanke’s watch than it would have done were Mr Greenspan still in charge.

Conclusion

Mr Bernanke is a good choice to be the next Chairman of the Federal Reserve. His views are similar to Mr Greenspan’s in many ways and we can expect little change in the way that monetary policy in the US is managed when he takes over. Probably the most noticeable change will be the adoption of a formal inflation target.

Financial markets are right to have reacted very little to the announcement; though they may prove jitterier should Mr Bernanke have to face an economic or financial crisis soon after he takes over.

Tony Dolphin

Director of Economics and Strategy

Henderson Global Investors

This document has been produced based on Henderson Global Investors' research and analysis and represents our house view. The information is made available to clients only incidentally. The sources for all data are Henderson Global Investors and Datastream.

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