New chairman, new tactics for the Federal Reserve

Ben Bernanke

When Ben Bernanke takes over at the Federal Reserve today, he will be the first chairman in more than five decades who hasn't faced the urgent task of lowering inflation.

"He's the world's greatest inflation-targeter, with no inflation to target," said Stephen Roach, chief global economist at Morgan Stanley, at the World Economic Forum in Davos, Switzerland.

That doesn't mean the Bernanke Fed will sit on the sidelines with nothing to do. With inflation under control, the new chairman has signalled that the central bank will be freed to deal with the broader concern of managing growth amid widening deficits, globalisation of the labour market and unexpected booms and busts in the prices of homes and financial assets.

"If the Fed can maintain credibility for sustained, low inflation, it will have more leeway to work to stabilise the economy," says Alfred Broaddus, president of the Richmond Fed from 1993 to 2004.

That's a tall order, one carrying risks of its own. Recent history in the United States and Britain shows central-bank actions to correct one imbalance may create others, either by stalling growth or inflating new bubbles.

"We will be having to make more judgments about the evolution of economic fundamentals," said Richmond Fed president Jeffrey Lacker. That process "is analytically difficult".

The strategy taking shape within the Fed builds on the "risk management" approach to policy that former chairman Alan Greenspan, 79, has been formulating over the past several years.

The concept is that once inflation is locked down, policy-makers have the luxury of acting to offset other issues that inhibit economic performance.

Such action by the Fed isn't unprecedented. With the economy growing at a 4.2 per cent annual rate in 1998, the Fed cut interest rates three times between September and November to cushion the blow of tumbling financial markets after devaluation of the Russian currency.

Bernanke, 52, has endorsed the risk-management approach. "Risk analysis of this type is a necessary component of successful monetary policymaking," he said in November.

With the consumer price index up 3.4 per cent over the past 12 months, a Fed transition hasn't occurred at a lower inflation rate since President Harry Truman made Thomas McCabe chairman in April 1948.

"The job of the Fed is easier when long-term inflation risks are anchored," Kenneth Rogoff, a Harvard University economist, said in Davos. "It can engage in stabilising the economy much more aggressively without inflation expectations being pushed higher."

Rather than aiming policy at getting inflation down, the Fed's analysis is likely to turn towards what might unseat prices from an already low level.

That requires judgments about whether the Fed's policy rate is causing too little or too much use of the economy's resources.

"If demand for resources is pushing economic activity to a rate that is faster than sustainable given our forecast, it would signal our policy rate is too low," Richmond Fed research director John Weinberg said last week.

"If demand is low, a policy rate that is too high could cause unwanted disinflationary pressures."

He says financial markets, economic indicators and anecdotal evidence may initially say more than inflation readings about the appropriate level of the Fed's policy rate.

Lacker described a world in which the Fed will still be adjusting interest rates "even if inflation pressures subside".

That would likely require greater disclosure of the forecasts and analysis driving those decisions so the public understands why they are happening.

Laurence Meyer, a Fed governor from June 1996 to January 2000, said the new chairman would stamp the risk-management strategy with his own style and help the Fed evolve towards greater transparency.

"Bernanke is a much more vigorous and passionate advocate of transparency than Greenspan," Meyer says.

"We will see more frequent publication of Federal Open Market Committee forecasts, clearer testimonies and richer monetary policy reports."

Recent experiences at the Fed and the Bank of England point up some of the hazards of trying to stabilise a large economy.

The Bank of England raised interest rates five times in 10 months from August 2004, trying to cool a housing boom that led consumers to take on a record £1.1 trillion ($2.85 trillion) in debt. Growth in Europe's second-largest economy slowed to 1.7 per cent last year from 3.2 per cent in 2004.

Meanwhile, the Fed kept its policy rate at a 46-year low of 1 per cent from June 2003 to June 2004 to offset the risk of an "unwelcome substantial fall in inflation".

Between June 2003 and June 2005, average house prices jumped 22 per cent and, by last May, Greenspan was calling the real estate boom "unsustainable".

Household saving out of personal income vanished last year as home-equity withdrawal allowed consumers to spend more than they earned. The Fed's ratio of how much mortgage and consumer debt households carry, relative to disposable income, rose to 13.75 per cent in the third quarter last year, the highest in records going back to 1980.

"The US economy has lots of vulnerabilities in debts and deficits," Joseph Stiglitz, a Columbia University professor and winner of the 2001 Nobel Prize in economics, said in Davos last week.

"Raising rates will have a much more negative effect on the economy" and Bernanke should "focus on growth".

Since June 2004, the Fed has raised the benchmark rate 13 times. Allan Meltzer, a Fed historian and economist who teaches at Carnegie Mellon University in Pittsburgh, said the Fed should focus on keeping inflation and unemployment low, and avoid the political risks of a bold macroeconomic stabilisation strategy.

- BLOOMBERG