Immediate Policy Test Awaits

A surging stock market on Monday suggested rousing approval on Wall Street of President Bush’s choice of Ben S. Bernanke to head the Federal Reserve.

But for investors and consumers, the choice of a successor for Alan Greenspan still leaves open the big questions of Fed policy: How much higher will the central bank raise interest rates, and how long will it keep them up?

If approved by the Senate, Bernanke, chairman of the White House’s Council of Economic Advisors, would step into the Fed’s top post at what could be a crucial moment: For the first time in more than a decade, inflation worries are mounting, largely because of the surge in energy costs.

The Fed may have to choose between strong economic growth and stamping out inflation by tightening credit more significantly than it already has. The Fed has raised its key short-term rate 11 times since June 2004, to a four-year high of 3.75%.

And just as Greenspan faced a raging stock market when he took over the Fed in the summer of 1987, Bernanke would have to deal with a red-hot housing market that could be snuffed out by higher interest rates.

Bernanke “is going to be immediately tested,” said Bill Gross, chief investment officer at Pacific Investment Management Co. in Newport Beach, one of the world’s biggest bond investors.

For owners of fixed-rate bonds, inflation is public enemy No. 1. And the bond market’s reaction to Bernanke’s nomination on Monday was notably cooler than that of the stock market, where the Dow Jones industrial average jumped 169.78 points, or 1.7%, to 10,385.00, the largest one-day gain since April.

The 10-year Treasury note yield, a benchmark for mortgage rates, climbed to 4.45% from 4.38% on Friday. Investors often demand higher yields on bonds when they’re worried about rising inflation.

Bernanke’s image on Wall Street has been largely shaped by comments he made in November 2002, in what’s now known as the “helicopter speech.” In that address, Bernanke, then a Fed governor, focused on the risk that the then-struggling economy could fall into deflation, meaning a downward spiral of prices and wages.

Bernanke detailed how the Fed could use its various tools to spur consumer and business spending, including by jumping into the bond market to directly buy Treasury securities in an effort to push down longer-term interest rates. Combined with federal tax cuts, he said, the effect would be a “helicopter drop” of money into the economy -- a phrase coined by eminent economist Milton Friedman.

The speech left many analysts with the view that Bernanke would always tilt toward supporting economic growth, perhaps even if inflation, not deflation, was the issue.

But some experts say the characterization is unfair.

“A lot of people perceive him as dovish [on inflation]. I don’t think that’s really true,” said Bill Dudley, economist at brokerage Goldman Sachs & Co. in New York. The helicopter speech, Dudley said, was made at a time when deflation was a legitimate concern, and Bernanke was merely reflecting those fears.

Now, energy-driven inflation is the obvious worry, not deflation, economists say. And some believe that Bernanke wouldn’t be any less tolerant of higher inflation than Greenspan.

Ethan Harris, economist at Lehman Bros. in New York, said Bernanke had previously indicated a “comfort range” of 1% to 2% a year for a key inflation gauge, the so-called core personal consumption expenditures deflator. If that’s still Bernanke’s favored range, the index already is at the upper end of it -- which would imply that he would want the Fed to continue tightening credit until policymakers were sure inflation was coming down.

Notably, Bernanke has said the Fed should set a definite target for an acceptable level of inflation and make it public. Greenspan has opposed the idea, fearing it would mean less flexibility for the Fed in responding to shifts in the economy.

Inflation targeting would clarify the Fed’s mission and make its moves easier to understand, said Charles Plosser, an economist at the University of Rochester in New York.

Moreover, Plosser said, it would make the central bank less subject to the agenda of one person -- the Fed chairman -- no matter how charismatic or capable.

Bernanke has in general supported the idea of making Fed policy more transparent to the public. Many investors say they favor a more open Fed as well.

“As a bond trader, I welcome transparency,” said Robert Gahagan, senior portfolio manager and director of taxable bond investments at American Century Investments in Mountain View, Calif. “There is nothing worse than being totally surprised” by Fed policy shifts, he said.

But Greenspan already has moved Fed policy much more into the sunlight. It wasn’t until after Greenspan took over that the Fed began publicly announcing its interest rate moves.

Increasing openness by the Fed also creates its own problems, however. For example, by telegraphing so clearly since early 2004 that the Fed would go slow in raising interest rates from what were then generational lows, Greenspan fostered a climate of excessive speculation in the financial and housing markets, his critics say. Speculators had no fear of a sudden, and severe, credit-tightening move.

Greenspan himself has suggested in recent speeches that some investors have taken on too much risk, betting on “prolonged stability” in markets.

Bernanke would inherit that potential problem, as well as the challenge of steering the Fed in a world in which increasing globalization of the economy and markets has, to some degree, subverted Fed policy.

Greenspan saw the effects of globalization as long-term U.S. interest rates stayed surprisingly low over the last year, even as the Fed was raising short-term rates. In part, China’s heavy buying of U.S. bonds, as it recycled its trade-surplus dollars, kept the Fed’s tightening moves from having their full effect.

Globalization, Harris said, “adds a whole new set of complications to Fed policy.”