Video: Bush names successor to Greenspan

By Martin Wolk Executive business editor
msnbc.com
updated 1/27/2006 11:43:17 AM ET 2006-01-27T16:43:17

Although Federal Reserve Chairman Alan Greenspan is departing the national stage with the economy in relatively good shape, his designated successor Ben Bernanke faces a daunting list of risks and potential pitfalls.

At the top of the list are rising inflation fueled by soaring energy prices and the possibility that high-flying housing markets will come back to earth with a thud as mortgage interest rates rise.

President Bush in October nominated Bernanke, chairman of his Council of Economic Advisers and a former Fed governor, to take over the central bank when Greenspan steps down Jan. 31. The nomination is subject to approval by the Senate.

Analysts say Bernanke will have to act quickly to establish his credentials as an inflation fighter, possibly by raising interest rates more aggressively than otherwise would have been required. Bond prices fell on news of the nomination, sending long-term interest rates slightly higher on concerns Bernanke might not be sufficiently tough on inflation, market analysts said.

Although the economy faces daunting long-term challenges including a large federal budget deficit, an intractable trade gap and a shortage of national savings, Greenspan has achieved what most analysts describe as a smooth landing after the shocks of the past several years.

Even as the Fed has raised rates sharply from their lowest levels in half a century, the economy has added jobs steadily, pushing down the unemployment rate to about 5 percent. Inflation is rising and consumer confidence is shaky, but there is little evidence yet that rising fuel prices have spread to the broader economy or crimped consumer spending.

“It’s a storybook ending to a wonderful career,” said Mark Zandi, chief economist at Economy.com.

Yet the delicate rate-hike campaign is not yet over, and the transition to a new Fed chief is always filled with uncertainty and risk for financial markets. The stakes are even higher today considering the high level of comfort professional investors and the public at large have with Greenspan after his more than 18 years in office.

“(The Fed) has gotten to be embodied in the person of the chairman to a degree that is unhelpful when it comes time to appoint a new chairman,” said Pierre Ellis, senior economist at Decision Economics.

The cult of personality that has evolved around Greenspan is one reason other Fed  policy-makers have been increasingly vocal in recent weeks, said Ellis. Greenspan’s fellow governors and regional Fed presidents “have been making an effort to speak as one” to reassure financial markets of the central bank’s unwavering determination to keep simmering inflation under control.

As a Fed governor, Bernanke was best known for publicly raising the possibility the U.S. economy could enter a damaging period of deflation much like what Japan went through in the 1990s. Economists who have followed Bernanke's career say there is no reason to think he would be any less aggressive in fighting inflation, but financial markets always react skeptically to a new Fed chief.

Major Market Indices

The onset of G. William Miller’s brief 17-month tenure in March 1978 ushered in a dollar crisis, and bond markets “tanked” when  Paul Volcker took over in 1979, Morgan Stanley chief economist Stephen Roach noted in a recent commentary. Bond prices also fell in 1987 when Greenspan was named to succeed Paul Volcker, who had earned Wall Street’s respect by breaking the back of inflation in the early 1980s, although at the cost of two difficult recessions.

Then just two months after taking office, Greenspan faced one of the most difficult tests of his term when the Dow Jones industrial average lost 23 percent in a single day and financial market operations nearly melted down.

“Just from that perspective alone, there’s good reason to worry about the markets in early 2006,” Roach said.

Few economists are expecting that kind of doomsday scenario to greet Bernanke, who is expected to win relatively easy confirmation from the Senate. But there is little doubt the new chief will be severely tested in a term that is scheduled to run at least four years and could go as long as 14 years if he is reappointed by future presidents.

The value of a Fed chief  “is when the economy is in crisis, how they manage through that crisis,” said Zandi. “That is what made Greenspan so valuable and so successful.”

His vote for the most likely source of the next financial crisis: The red-hot housing market.

“I think there likely will be some credit problems as the housing market cools and prices weaken,” he said. “Under a dark scenario, global buyers could start selling mortgage-backed securities, and it would be in that environment that a crisis could unfold.”

Other analysts point to the housing market as well as to the possibility that energy prices — which have moderated slightly after the disruptions of Hurricanes Katrina and Rita — could rise again next year.

Although financial markets could be a bit jittery as the Fed prepares for its first leadership change since the 1980s, investors are likely to encouraged by President Bush's choice of the favorite candidate, who has both extensive Fed experience and a strong economic pedigree.

In any case there it would not be surprising to see Bernanke boost interest rates at the first opportunity — as Greenspan himself did in 1987 — to establish or reinforce his credentials as an inflation-fighter.

Not everyone agrees that Bernanke will have to act aggressively. Most forecasters figure the Fed will raise interest rates at least two more times before Greenspan’s Jan. 31 retirement,  pushing the benchmark overnight rate to over 4 percent, compared with 1 percent when the Fed began tightening in mid-2004.

Economists figure the current “neutral” federal funds rate is between 4 and 5 percent, so if the Fed pushes up rates at Greenspan’s final meeting Bernanke might legitimately call for a pause at his first or second meeting next year.

Raising rates is not the only way a new Fed chairman can establish his inflation bona fides, said Richard DeKaser, chief economist for National City.

“The easy way for the incoming chairman to do this is simply using the bully pulpit and express their concerns about rising inflation pressures,” he said. “They can basically talk the talk. A more assertive posture would be to walk the walk.”

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