Fed’s Change Comes at Dicey Time for Economy

Ben S. Bernanke will take over from the legendary Alan Greenspan as chairman of the Federal Reserve on Wednesday at a particularly dicey time for the nation’s apparently robust economy.

As a result, Bernanke will face a difficult choice walking into his new job: whether the Fed should continue -- or suspend -- its recent campaign of raising interest rates.

Unemployment is below 5%, as President Bush is likely to remind the nation in his State of the Union address tonight. Inflation is moderate. Workers are becoming more productive.

But potential trouble is bubbling beneath this calm surface. After remarkably consistent growth for three years, the economy slowed at the end of 2005. The housing market, which has fueled growth, is showing signs of cooling. Oil prices are high. Americans are spending more than they earn, a trend that can’t last forever.

And the United States is deeply dependent on foreign lending -- particularly from China -- to finance its outsized trade and budget deficits.

The Fed, whose job is to keep prices stable without suppressing economic growth, has already done the easy work.

For the last 20 months, Greenspan’s Fed has tapped on the monetary brakes at every opportunity, gradually raising short-term interest rates. In June 2004, the rate controlled by the Fed stood at a recession-fighting low of 1%. In 13 equal steps, the Fed has raised it to 4.25% to fight inflation and prevent the economy from overheating.

The Fed has signaled the public to expect another rate hike at today’s meeting, which will be Greenspan’s last. That will nudge its benchmark rate to 4.5%, the low end of the range at which analysts have estimated the Fed would stop.

From then on, the Fed -- it will be Bernanke’s Fed -- will have to decide when enough is enough.

If it continues to raise interest rates, consumer debt repayments could become more difficult and the housing market could feel the pinch. But if the Fed ends the rate-hike campaign, it will increase the risk of inflation, which is probably more of an immediate threat now than it was a year-and-a-half ago.

“Broadly speaking, the economy is in a pretty good place,” said Mark Zandi, chief economist of Moody’s Economy.com in West Chester, Pa. “But it’s no longer obvious what the next step should be. Now it gets a lot more complicated.”

Whatever the Bernanke Fed does, the new chairman will not do it single handedly. Interest-rate decisions are made by the Federal Open Market Committee, which consists of Bernanke and the six other Federal Reserve Board governors, plus five of the 12 regional Fed bank presidents.

Greenspan, by virtue of his stature as well as his persuasive skills, generally carried the other committee members with him. During the 13 consecutive meetings at which the committee raised rates by one quarter of a point since June 2004, only one dissenting vote was cast -- by a member who, immediately after Hurricane Katrina, felt the Fed did not have enough information about the hurricane’s economic impact to vote intelligently.

But now, “the guy who’s kept them on a leash is going to disappear,” said Lawrence Lindsey, an economist who was a Fed board member from 1991 to 1997 -- and who voted against Greenspan’s majority four times in 43 opportunities. He predicted stormier times ahead at the closed Open Market Committee meetings.

Bernanke’s first meeting, however, will be eight weeks into his tenure, time enough for him to begin to build consensus, said Kevin A. Hassett, director of economic studies at the American Enterprise Institute, a conservative Washington research organization.

“There is going to be a lot of uncertainty in the first couple of months, but Bernanke will quickly establish himself,” Hassett said.

Bernanke’s first rate-hike decision will be influenced by Greenspan’s last official pronouncement -- the statement that the Open Market Committee issues today to explain its expected move to raise the federal funds rate by another quarter point, to 4.5%. The federal funds rate is the interest on overnight loans between banks.

David Kelly, managing director of Putnam Investments in Boston, said Bernanke would find it politically difficult, without help from Greenspan, to preside over the end of 14 consecutive rate increases choreographed by the maestro of monetary policy. Greenspan can -- and Kelly said he should -- construct a statement at today’s meeting explaining the rate increase in such a way that leaves his successor maximum flexibility to act as he sees fit.

“This will be potentially the most important Federal Reserve Board meeting of the decade,” Kelly said. “On Alan Greenspan’s last day on the job, he’s going to have a chance to leave the car parked in neutral.”

“As an economist, I’m more worried about the economy slowing down than I am about inflation,” Kelly said. “The biggest mistake the Fed usually makes is believing it needs to run the economy. It just needs to get monetary policy into neutral and let the economy run itself.”

Economists generally see the Fed’s goal to be a “neutral” federal funds rate -- one that is two percentage points higher than inflation. With inflation now running 2% to 2.5%, depending on how it is measured, a neutral federal funds rate should be in the range of 4% to 4.5%. It’s already there, although there is room for one more increase today.

Many analysts, however, find it unlikely that Bernanke will let up on the monetary brakes immediately, even if that means lifting interest rates above the neutral zone.

Echoing the views of many others, Jan Hatzius, chief U.S. economist for Goldman Sachs, says Bernanke will want to prove his anti-inflation credentials by engineering at least one more rate increase.

Looking beyond Bernanke’s first Fed meeting, Zandi warned of the dangers that set in when an economic expansion gets long in the tooth, as this one is. In those situations, he said, policymakers can no longer encourage economic growth with little risk of inflation.

“Now we’re at the point in the business cycle when the economy could slip a gear,” Zandi said. “I think [Bernanke] should plan on it.”

Fed chairmen have sometimes undergone trial by fire early in their tenure. In the case of Greenspan, who became Fed chairman in 1987 at about the same stage of the business cycle as now, an October stock market crash sent the Dow Jones industrial average tumbling nearly 23% in a single day.

Thanks in large measure to the Fed loosening its grip on the money supply, the economy weathered that storm without a recession.

Zandi said there was no shortage of flash points now. To him, the potential for a cooling of the red-hot housing market is the “major fault line in the economy.” Home equity loans and no-down-payment mortgages have provided millions of Americans with spending money -- but less equity in their homes. A downturn in home values could leave them owing more on their homes than they are worth.

Already, existing home sales fell 5.7% in December, and housing starts tumbled to their lowest level since last March. And an increase in short-term rates, if they translated into higher long-term mortgage rates, could contribute to a housing reversal.

Another “fault line” is U.S. reliance on foreign money, particularly China’s, to finance its trade and budget deficits. If foreign governments decided they had invested enough, the need to attract other investors would drive U.S. interest rates up independent of any Fed action, to the detriment of economic growth.

Energy prices represent a third threat, and one that could be aggravated by higher interest rates. Philip Verleger, a senior fellow with the Institute for International Economics, can imagine the world oil price, now in the range of $60 to $70 a barrel, surpassing $100 by year’s end.

Whatever Bernanke does, he inevitably will be compared with Greenspan, who, despite scattered critics, is probably the most highly regarded top official in Washington.

“Bernanke is replacing a legend,” said Stephen Buser, professor emeritus of finance at Ohio State University. He noted that Earle Bruce, who replaced the legendary Woody Hayes as head coach of the Ohio State University football team, was fired even though his teams won as many games as Hayes’.

“Even if Dr. Bernanke made the same decisions as Alan Greenspan,” Buser said, “they might not have the same result.”

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Greenspan’s 18 1/2-year tenure

Aug. 11, 1987: Greenspan takes over at the Fed after being picked by President Reagan to succeed Paul Volcker. He is renominated by presidents George H.W. Bush, Clinton and George W. Bush.

Oct. 19, 1987: “Black Monday.” The Dow Jones industrial average suffers a record one-day plunge of 23%. Greenspan spurs a rally the next day when the Fed issues a statement promising to lend to any financial institutions in distress.

July 1990: The economy enters a brief, mild recession in which oil prices surge after Iraq invades Kuwait on Aug. 2.

March 1991: The recession ends and a record 10-year economic expansion begins.

Feb. 4, 1994: The Fed for the first time announces publicly that it is changing its key policy lever, the federal funds rate.

September 1996: Greenspan persuades his Fed colleagues not to raise interest rates, arguing that worker productivity is rising faster than government statistics are showing and that this will allow unemployment to fall to lower levels without generating unwanted inflation.

Dec. 5, 1996: Greenspan delivers a speech in which he wonders whether the stock market’s rise reflects “irrational exuberance.” Stocks plunge but then resume rising.

Sept. 29, 1998: The Fed announces the first of three rapid-fire interest rate reductions in a successful effort to cushion the U.S. economy from the Asian currency crisis and the near-collapse of a giant hedge fund.

Jan. 14, 2000: The Dow Jones industrial average hits an all-time high of 11,722.98. In coming months, the stock market plunges in value, wiping out trillions of dollars in paper wealth.

Jan. 3, 2001: The Fed unexpectedly cuts interest rates between meetings by half a percentage point, beginning an aggressive series of moves to bolster the economy in the wake of the market decline and a sharp drop in business investment.

Jan. 25, 2001: Greenspan testifies to a congressional committee that huge projected federal budget surpluses, which never materialize, provide room to cut taxes. The comments help President Bush win approval for $1.3 trillion in tax cuts.

March 2001: A recession begins, ending the longest expansion in U.S. history.

Sept. 11, 2001: Greenspan is returning from a conference in Europe when his plane is diverted from U.S. airspace because of the terrorist attacks. Fed Vice Chairman Roger Ferguson releases a statement saying the Fed stands ready to provide loans to banks in financial distress.

November 2001: The recession ends but job losses mount as businesses strive to be more competitive with smaller workforces.

June 25, 2003: The Fed cuts its target for the federal funds rate, the interest banks charge one another, to 1%, the lowest level in 45 years, as it tries to jump-start economic growth while guarding against the possibility of deflation, or a sustained decline in prices.

June 30, 2004: The Fed begins the first in a series of quarter-point interest rate increases to gradually remove economic stimulation. The 14th rate hike in this series, which would push the federal funds rate to 4.5%, is expected today.

Oct. 24, 2005: Bush announces that he will nominate Ben S. Bernanke, chairman of the president’s Council of Economic Advisors, to succeed Greenspan.

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Source: Associated Press

Los Angeles Times