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|  | NOVEMBER 14, 2005
By David Wyss Bernanke's Bumpy Road AheadAlthough the incoming Fed chairman will inherit a strong economy, he faces a bunch of tricky issuesAs the apparent incoming head of the Federal Reserve Board, Dr. Ben Bernanke has a tough act to follow. Alan Greenspan has been perhaps the most successful Fed chairman in history, with inflation remaining calm and only two mild recessions during his 18-year tenure.That means the incoming chairman will inherit a stable economy, with low inflation and solid growth. Yet the problems and imbalances he must handle are big. Here's a look at some of them. Item No. 1 on the central bank's agenda is always inflation. The sharp rise in energy prices and construction costs caused by the rebuilding of New Orleans has brought that to the fore again. In his academic work and at the Fed, Bernanke has been known as an advocate of inflation targeting (see BW Online, 10/25/05, "Bernanke on the Record"). We expect him to move gradually toward that policy as chairman. HAWK OR DOVE? The second agenda item has to be the U.S. financial market's dependence on foreign capital to finance America's deficits. The lack of household saving (now negative for a record four months) and the rising federal deficit in the wake of Hurricane Katrina make us dependent on this massive inflow of private and official money. What happens if foreigners stop shipping us all their spare cash? No. 3 is the heavy borrowing of the household sector and the related housing boom, which has enabled that borrowing. Household debt is at a record 124% of household aftertax income. The new bankruptcy law and Katrina created a flurry of bankruptcies, as debtors filed before the new legislation became effective on Oct. 17. As a result, charge-offs will peak in the fourth quarter. At the current inflation rate, a move to formal targeting is largely a semantic step. A lot of ink has been wasted in trying to decide whether Bernanke is a hawk or a dove on inflation. The chairman-designate is really a pigeon hawk -- Falco columbarius (see BW Online, 10/24/05, "Answers About Ben Bernanke"). If inflation drops, he'll look like a dove; if inflation rates rise, he'll seem very hawkish. GREENSPAN'S EXIT STRATEGY. Fed spokesmen, including Bernanke as a member of the board, have focused on a range of inflation of 1.5% to 2% as ideal. The usual rate cited -- the deflator for core personal consumption (excluding food and energy) -- has been Chairman Greenspan's favorite. In September that deflator was up 2% from a year ago, the top of the range and the same as the core CPI. We expect this rate to creep upward, to around 2.5%, over the next year. Of the other likely rate candidates, the core consumer price index, as measured by the new chain-weighted index, is up 1.8% over the last year; and the core market-based deflator, which includes only items that are actually priced rather than imputed, is up 1.7%. The inflation rate is thus either at the top end or well within the likely target range. Moreover, the Fed is already raising rates. The question is when the Fed can stop. Both Greenspan and his predecessor, former Fed Chairman Paul Volcker, began their terms by raising interest rates. Greenspan remembers that, in his case, it helped result in the biggest one-day drop in U.S. stock market history -- only two months after he took office. He'd probably prefer to put the funds rate where he thinks it should be before leaving office, thereby giving Bernanke the freedom to move next in whatever direction he needs. DISLOCATED DATA. If the new chairman does stop raising rates, it shouldn't be assumed that he's a dove. Rates will be, after all, up 350 basis points from June, 2004 (assuming 0.25 percentage points in rate hikes at each of the next two Fed meetings). It'll be time to stop and take stock before moving rates even higher. Yet if oil prices surge further, rates may have to follow. The surprise of late has been how little of the rise in energy prices has spilled over into the core inflation rate. This was in part because wage increases have remained low and productivity strong. In the 1970s, the jump in oil prices was associated with a slowdown in productivity growth; so far, productivity has barreled along in this cycle. The economy Bernanke will inherit is in good condition. Although the October payroll rise of 56,000 was disappointing, the September drop was revised to only 8,000, and the unemployment rate fell to 5%, where it's expected to stabilize. The data are still uncertain because of the dislocation in the hurricane-ravaged regions around New Orleans. STRONG CONTEXT. The job picture in that area is largely a guess. Still, weakness in hospitality and leisure, as well as retail, suggests businesses are nervous about consumer spending on anything other than energy. We expect gross domestic product growth to slow but remain solid -- in the range of 3% to 3.5% -- over the next five quarters. So, despite the challenges Bernanke will face, he'll be acting in the context of a strong economy.  Wyss is chief economist for Standard & Poor's Edited by Patricia O'Connell
BW MALL
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