There has been a strange sense of anti-climax to the changing of the guard at the United States Federal Reserve, announced out of the blue last week.
There was none of the worldwide outpouring of grief, for example, that accompanied the death of Pope John Paul II earlier this year. But make no mistake, the end of Alan Greenspan’s reign at the Fed is as key a moment for the world’s financial markets and economy as a change of pope is for the Catholic church.
Everyone knew that 79-year-old Greenspan’s fourth term was to expire at the end of January. It is just that for 18 years he has been in the hot seat of the world’s most powerful central bank and that made it difficult to imagine life after Greenspan until it actually happened.
But, assuming that the senate approves US President George Bush’s nomination of Ben Bernanke, his chief White House economic adviser, to the role, then change there will be and Greenspan will head off into the sunset and perhaps pore less over economic data every month (although you would not bet on it) and worry less about irrational exuberance in the markets.
So what do we make of the Greenspan years and how will history judge him? It it is too early to tell. Not surprisingly, he has attracted as many detractors over the years as fans, being labelled ”maestro” by supporters while others have accused him of allowing imbalances to develop that threaten to tip the United States and global economies into an almighty slump.
As yet we do not know, for example, what will become of the US housing bubble, if indeed it is a bubble. We do not know how painful the eventual unwinding of the US enormous budget and current account deficits will be. And we do not know whether inflation — which is higher today than when Greenspan took over at the Fed in 1987 — will continue rising and require a sharp rise in interest rates to bring it back under control. In other words, judgement day for Greenspan lies somewhere in the future, although probably not too far.
Shrewd operator
But we do know that US inflation has been low on his watch — averaging 3% over 18 years — while economic growth, particularly in the second half of his tenure, has been strong and remains strong. While not all of this success can be attributed to Greenspan alone, his shrewd operation of monetary policy will always be considered to have made a significant contribution.
But the flipside of the strong growth, which has sucked in imports and capital from around the world, is a giant current account deficit now heading for an unprecedented 6,5% of gross domestic product. Greenspan stands accused of allowing the dotcom bubble to inflate so far in the late 1990s that it burst spectacularly, at which point he slashed interest rates and allow another bubble — in housing — to inflate.
That is happening alongside very little saving by Americans, who prefer to regard their rising house prices as a form of saving and extract money to fund consumption by remortgaging. A similar phenomenon, although less powerful, has been occurring in Britain in recent years. Combined with all this are oil prices that are close to record highs, which have pushed up inflation to uncomfortable levels and threaten to restrict consumer spending.
Into this situation, with its many potential pitfalls, steps 51-year-old Bernanke. Financial markets took the news of his appointment in their stride last week, and rightly so. He is one of the finest monetary economists of his generation and already has three years at the Fed behind him.
Upon his arrival at the Fed in 2002, he argued that the central bank must do everything in its power, including flooding the economy with money, to prevent the economy sliding into deflation — a very real danger at that time. This has led some economists to think that Bernanke is soft on inflation. He is not but he is prepared, as Greenspan always was, to consider any solution to potential problems.
His preparedness to keep inflation in check is amply demonstrated by his consistent support for a system of inflation targeting, such as that of the Bank of England. The Fed’s mandate is to pursue maximum growth and employment with stable inflation. Bernanke has argued, as does the BoE’s governor, Mervyn King, that an explicit inflation target helps anchor people’s expectations of inflation at that figure.
Bernanke has already stressed that he intends to continue in the Greenspan mould. While he may struggle to persuade his colleagues on the federal open markets committee (which sets interest rates) to adopt a specific target, he is likely to continue to increase the Fed’s transparency about what it wants to see from the economy and how it plans to get there. He has already made it clear that he considers inflation of 1%-2% to be a ”comfort zone” and is likely to be more vocal about that in future.
He may try to depersonalise the role of the Fed chairman in setting interest rates, as King has tried here with some success. It is unhealthy, as King has argued, that the health of the world’s largest economy becomes inextricably linked with one person, with their every utterance studied under the microscope. The most immediate problems confronting Bernanke when he takes control on February 1 are likely to be the booming house market, in some areas at least, and inflation. Interest rates by then are very likely to be 4,25% or 4,5%, having already been raised 11 times since last summer from an ultra-low 1%.
Bernanke may still face the same ”conundrum” that Greenspan has spoken of: that long-term interest rates, which govern most Americans’ mortgages, have remained remarkably low in spite of the successive rises in the Fed funds short-term interest rate. Normally, long rates would have risen sharply by now.
Soft landing
With a bit of luck — something that all policymakers, no matter how smart, need — the higher rates will cool the housing market and encourage more Americans to save more. If that happens gradually, then the Fed will have achieved the desired ”soft landing” for the economy.
Lower spending by Americans should also start to shrink the US current account deficit. That will mean lower exports for countries such as China and Germany, which have depended on the thriving US economy for their own prosperity in recent years.
Indeed, Bernanke has made it clear that he does not think that the current account deficit is a problem made in the US. He blames other countries, especially in Asia but also Europe, for having an excess of savings which they deposit in the US looking for returns. He has called this a ”global savings glut”. If domestic demand in those countries were higher, he argues, the current account deficit would be far smaller. This is a controversial view and will remain a live issue in the future.
Bernanke has also spoken in favour of a weaker dollar as a method of reducing the deficit by making US exports cheaper and imports dearer. There is, however, a world of difference between an orderly slide in the dollar, such as has been seen in the past few years, and a sharp fall. That could destabilise the US economy, causing interest rates to rise sharply and forcing the economy into recession. That would certainly cure the imbalances but it would be very painful.
Still, lots of people have written off the US economy before and warned that it was all about to go badly wrong. It hasn’t yet, though, and Bernanke will inherit a strong economy with productivity growth that other countries can only dream of. A disaster is far from a done deal. – Guardian Unlimited Â