Bernanke faces immediate tests that could determine economy's fate

WASHINGTON—On Tuesday, Federal Reserve Chairman Alan Greenspan hands over the reins for steering the world's largest economy to his successor, Ben S. Bernanke.

Greenspan's final official act is expected to be presiding over a 14th consecutive quarter-point interest rate hike, bringing to 4.5 percent the benchmark federal-funds rate that banks charge each other for overnight loans, which directly affects consumer loans.

Bernanke's first big test will be determining when and how to break this streak of rate increases, which began in June 2004.

It's no small question, and the answer will have tremendous impact on all Americans.

Raise rates too high and housing prices could slump, credit card fees could surge and the cost of borrowing for college or a new car could become punishing.

Ease credit too soon and risk being seen by global financial markets as soft on inflation. Investors in stocks and bonds, traders in currencies and gold, and foreign governments that buy U.S. government debt could all lose confidence in Bernanke's monetary management. That could spark a crisis that spreads across the globe.

So what to do? Keep raising rates? Pause? Begin cutting?

"I think there's some pressure for the Fed to keep going over the near term," said William Dudley, chief U.S. economist for Goldman Sachs & Co. in New York.

That's a view shared by James Paulsen, chief investment strategist for Wells Capital Management, a division of Wells Fargo Bank. In a January report to investors, Paulsen noted "this tightening cycle began from the lowest interest rate in almost half a century" and reverses steep defensive rate cuts made to boost the U.S. economy after the Sept. 11, 2001, terror attacks panicked the markets and risked recession.

"Without a `depression panic,' short-term rates probably would have bottomed fairly close to where they are today," Paulsen wrote. "Essentially, the Fed has just now returned interest rates back to recession lows and can now `begin' to tighten."

Many on Wall Street believe that Bernanke's Fed will continue raising rates. Futures markets, which project investor expectations, suggest a nearly 60 percent chance that Bernanke will keep tightening rates in March.

The Fed's mission is to preserve price stability by warding off inflation, the rise in prices across the economy. Inflation is most threatening during periods of economic growth, like now. The Fed seeks to raise rates high enough to contain inflation but not so high that they'll choke the economy. The federal funds rate is the tool the Fed uses.

Historically, long-term lending rates, including mortgages, rise in tandem with the federal funds rate. But that relationship is topsy-turvy as the Bernanke era begins. Long-term rates haven't risen over the latest cycle of short-term rate hikes. Instead, they've remained low, and low mortgage rates fueled a four-year nationwide housing boom.

Greenspan, widely viewed as the greatest central banker ever, declared the phenomenon of stagnant long-term rates amid rising short-term ones a "conundrum." Bernanke believes a "global savings glut" is the reason. Foreign investors and central banks in China, Japan and elsewhere are seeking a safe bet in long-term U.S. Treasuries, even though they pay relatively low returns.

Some think the uncertainty over the relationship between long and short rates is reason enough for a pause when Bernanke presides over his first rate-setting meeting on March 28 of the Fed's policy-making body, the Federal Open Markets Committee.

"I think there's a good chance that they don't tighten at his first meeting," said Richard Fedele, CEO of Summit Mortgage LLC in Boston. Housing is such a large part of the economy that Bernanke might want "to take a little time to see what the rate increases have done."

Bernanke must tread carefully, said Charles Calomiris, a financial expert at the Columbia University Graduate School of Business in New York.

If the Fed raises short-term rates high enough, it could push the economy to a tipping point. Investments bearing short-term rates would become more attractive than those paying long-term rates, which would force up the longer rates, including mortgages, and hurt the hot housing sector.

Much is beyond Bernanke's control, Calomiris noted, because foreign investment in U.S. Treasuries, especially from China and Japan, has had more impact on U.S. mortgage rates than have the Fed's short-term rate hikes.

"Can you think of a time ever when that was the case?" he asked.

China's central bank said in early January that it would diversify out of U.S. Treasuries this year, but it didn't say how much or when. It's an important question as the Bernanke era dawns.

Meanwhile, Wall Street and the financial media will surely pore over every statement from the Bernanke Fed, looking for any break with the past, indecision or dissent among Fed governors.

"The risk is that the alpha dog (Greenspan) is gone and the pack is going to start squabbling," said Kevin Hassett, a former Fed economist and scholar at the American Enterprise Institute, a conservative think tank.

Bernanke, he said, can secure his leadership role by clearly explaining his views on the economy and inflation risks when he delivers his first economic report card to Congress on Feb. 15.

The new chairman may have another unusual problem, following nearly 19 years of Greenspan, said Lawrence Lindsey, a Fed governor from 1991 to 1997. Greenspan, widely viewed as an economic sage, may no longer feel restrained about expressing his views in public.

"I don't think he's going to set out to create a conflict, but I do think that he will be unedited, and I think that increases the variance" with his successor's statements, Lindsey said.


Below is a review of crises faced by previous Fed chairmen as they took over their posts:

When Ben Bernanke takes the helm of the Federal Reserve on Jan. 31, he'll be mindful that his three predecessors faced crises early in their tenures, and sometimes throughout.

Only three months on the job, on Oct. 19, 1987, Alan Greenspan faced Black Monday, the largest one-day stock market plunge in U.S. history, when the Dow Jones industrial average fell by 508 points, or 22 percent of its value.

His predecessor, Paul Volcker, (1979-1987), raised short-term rates by 4 percentage points within his first three months as chairman in a painful bid to squeeze rampant inflation out of the U.S. economy. The effort provoked a crisis in bond markets and eventually a wrenching recession in 1981-82, but in the end inflation was tamed.

Before Volcker, G. William Miller (March 8, 1978-Aug. 6, 1979) lasted less than 17 months because he couldn't control inflation.

Like Bernanke, Arthur Burns (1970-1978) faced the challenge of succeeding a veteran Fed chairman. He followed the longest-serving chairman ever, William McChesney Martin (1951-1970), and struggled to contain inflation and foster economic growth amid the Vietnam War, oil shocks and the resignation of President Richard Nixon.


(c) 2006, Knight Ridder/Tribune Information Services.

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