On Tap for the Next Fed Chief: Trouble


By Rich Miller They came to praise Alan Greenspan. The financial elite from around the world descended on the picturesque mountain resort of Jackson Hole, Wyo., last week to pay homage to the Federal Reserve chairman before he gives up his job early next year.

With the snow-topped Grand Teton mountains looming majestically in the background, central bankers from 30 countries, top Wall Street execs, and leading academics used the occasion of the Kansas City Fed's annual economic conference to laud Greenspan for his 18 years atop the world's most powerful central bank. The three-day gathering was capped on Saturday, Aug. 27, by an extended standing ovation for the Fed chief from the traditionally straitlaced crowd.

There's no doubt that the 79-year-old Greenspan performed admirably during his tenure, piloting the U.S. economy through the stock market crash of 1987, two wars with Iraq, and the terrorist strikes of September 11, 2001. But as tough as those times were, his successor could face even more daunting challenges, including an increasingly globalized economy and a financial system over which the Fed's influence may well be on the wane.

It makes one wonder why anyone would want the Fed job. Here's a list of some of the tough challenges that lie ahead:

Asset Alignment: Perhaps the most difficult task Greenspan faced was in deciding what to do about the late 1990s stock market boom. After famously warning of "irrational exuberance" a decade ago, Greenspan adopted a hands-off approach to the Wall Street bubble, allowing it to build until it burst, then acting to shelter the economy from the impact through lower interest rates.

Some at the conference argued that this wasn't enough. Former International Monetary Fund (IMF) Chief Economist Michael Mussa said that such a one-sided policy encourages excessive risk-taking. "Policymaking needs to be concerned about countervailing the upside [of moves in asset prices] rather than just the downside," said Mussa, who's now with the Institute for International Economics, a Washington (D.C.) think tank.

The problem, from the Fed's point of view is twofold. The economics profession has only a rudimentary understanding of the effects of asset-price-driven shifts in household wealth. And the Fed itself has little direct effect on those asset-price movements through monetary policy. And when prices finally do respond to Fed actions, they can do so abruptly, making it even more difficult for the Fed to calibrate their impact.

During the late 1990s equities boom, share prices continued to soar for many months after the Fed started raising interest rates. Then they fell sharply. Similarly, over the last year home prices have continued to rise despite repeated Fed rate increases.

At the conference, Greenspan publicly admitted for the first time that real estate prices could fall. And he acknowledged that estimates of how big a hit that would deliver to the economy varied "quite widely."

In a throwback to his warning of irrational exuberance, Greenspan cautioned that investors may be becoming too complacent about the financial and economic risks ahead (see BW Online, 8/26/05, "Strategy Shift for the Fed?"). Former Treasury Secretary Robert Rubin, now a director at Citigroup (C), echoed that theme. "The next Fed chairman could face...serious market difficulties," he said.

Riskier Businesses: Those serious difficulties could be compounded by an increasingly complex -- and in some ways more concentrated -- global financial system. In a paper presented to the conference, IMF Chief Economist Raghuram Rajan argued that the world economy may be more susceptible to financial turmoil because of changes in how the markets work. "There is a small but growing possibility that we could have a catastrophic meltdown," he said.

According to Rajan, market deregulation has spawned a new breed of asset managers, including hedge funds and private-equity firms that are much more prone to taking risks with their investors' money than the staid bankers who dominated the financial system in the past. That's because the compensation of these new investment managers is directly tied to how much money they make for investors.

At the same time, because their performance is frequently compared to that of their competitors, the managers have little incentive to bet against a strong uptrend in the market, instead joining in the buying frenzy and adding to the froth. That, according to Rajan's argument, increases the risk of a bubble developing that would inevitably burst, with potential catastrophic consequences.

Rajan also contended that formerly conservative bankers face some of the same competitive pressures, which could spur them to assume greater risk. That could result in banks not being able to provide the markets with liquidity if turmoil strikes because they would be exposed to big losses as well.

Many central bankers at the conference were publicly skeptical of Rajan's paper. Fed Governor Donald Kohn maintained that deregulation had allowed risks to be spread beyond the banks to a greater number of financial market participants. That, he argued, has helped make the world's economies more resilient, not less.

But privately some central bankers were less sanguine. A particular worry: the growing concentration of the financial industry, with a few firms dominating trading in derivatives and other key aspects of the system. "It's nearly impossible to tell what large financial institutions on this planet are doing these days," said Arminio Fraga, former head of Brazil's central bank and now founding partner of the Gavea Investimentos hedge fund. And regulators like the Fed may lack the manpower and wherewithal to keep up with those institutions said Bank of Israel Governor Stanley Fisher.

Ties That Bind: In today's increasingly interconnected global economy, the Fed is already facing difficulties in managing monetary policy. Despite the central bank's nine short-term rate increases since last summer, long-term rates remain lower than when Greenspan & Co. began the current credit-tightening campaign.

A major reason, according to Rubin: foreign central banks buying U.S. Treasury securities. To prevent their currencies from appreciating against the dollar and thus making their exports less competitive, the central banks of China, Japan, and other Asian nations have bought up hundreds of billions of dollars on the foreign exchange market. They've then turned around and invested those dollars in the U.S., keeping bond yields low.

But that situation could change if the much-prophesied decline in the U.S. trade deficit finally materializes. In that case, the Fed could be faced with rising bond yields at a time when it might prefer to keep interest rates steady. University of California professor Sebastian Edwards told the conference that large countries typically see a 120-basis-point increase in interest rates when their trade deficit turns down.

Here's how it often plays out: Foreign investors, fed up with financing a country's ever-larger trade deficits, cut back on bond purchases. That pushes up interest rates. That, in turn, dampens consumer demand for everything, including imports, slows economic growth, and helps narrow the trade deficit.

If that ever happens to the U.S., the Fed could face an unpalatable choice: accepting the rise in interest rates engineered by foreign investors and the slower growth it might bring, or attempting to resist it by pumping more money into the economy, raising the risk of inflation down the road.

Fiscal Follies: The Fed could face the same sort of tough choices if the federal budget deficit balloons out of control as health care and Social Security outlays surge as baby boomers retire. The budget deficit will put upward pressure on interest rates, again landing the Fed in a tight spot.

Greenspan made clear where he stands. "Monetary policy cannot ignore the potential inflationary pressures inherent in our current fiscal outlook, especially those that could arise in meeting commitments to future retirees," he told the conference.

Greenspan was both good and lucky during his 18-year reign at the Fed. Perhaps the single most important economic development that occurred during his tenure was a sudden upsurge in productivity growth starting in the mid 1990s. Greenspan was smart enough to recognize it well before most economists and allowed it to blossom.

But he was also lucky to have productivity climb on his watch because that enabled the economy to grow faster without generating higher inflation. His successor may not prove to be as lucky, even if he is as good.

Miller is a senior writer for BusinessWeek in Washington, D.C.


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