For Bernanke, inflation heads list of risks

Martin Wolk Chief economics correspondent • Profile • E-mail

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.

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.

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