U.S.: Can Bernanke Please Two Masters?

He must win the bond market's trust and sell Congress on his policy ideas

Chairman Bernanke. It certainly has a different ring, doesn't it? Luckily for the economy, Wall Street seems to be adjusting well to the choice of Ben S. Bernanke to succeed the venerable Alan Greenspan as chairman of the Federal Reserve Board. Although the bond market first reacted to the news on Oct. 24 with some skepticism, stocks in the Dow Jones (DJ ) industrial average rallied to give the next Fed chief a 170-point vote of confidence. And why not? Bernanke had been the Street's expected choice for months, and his Senate confirmation will most likely be a breeze.

But it will be a short honeymoon. Bernanke takes over the Fed not only with new ideas on how to make policy but also at a crucial time for the economy. With inflation fears growing, policymakers are in the middle of a touch-and-go series of interest-rate increases that may well determine the fate of the current business cycle. The Bernanke Fed will have the task of deciding when to stop hiking. Overtightening policy could severely weaken growth in the economy, while undertightening could allow a broad pickup in inflation beyond the runup in energy costs.

For now, the choice of Bernanke to lead the Fed has not altered the outlooks for either the economy or Fed policy. That much seems clear from the generally positive initial reactions of the markets and economic forecasters. The financial markets still expect the Fed's target federal funds rate to reach at least 4.25% by spring, up from 3.75% now. And based on the expectations implied in the market for interest-rate futures, investors continue to believe the funds rate has a high probability of reaching 4.5% by April.

STILL, THE FED NOMINEE'S most immediate job will be winning the trust of the bond market. The future path of long-term interest rates will be crucial to the outlook for housing activity and home prices. The degree to which housing cools off in the coming year will go a long way to determining how much the overall economy slows.

Treasury notes sold off across the maturity spectrum on Oct. 24, pushing yields higher. The move was widely interpreted as a sign that bond folk harbor some concerns that Bernanke may not have the same commitment to fighting inflation that Greenspan did. However, that was hardly a vote of no confidence. The selloff lifted the yield on a 10-year note by only 6 basis points, from 4.39% to 4.45%. By contrast, the day Greenspan's appointment was announced back in 1987, bonds plunged, pushing the yield up by 35 basis points, from 8.43% to 8.78%.

The perception that Bernanke could be soft on inflation is fueled partly by the Fed nominee's first years as a Fed governor from 2002 to 2005, when he was outspoken about both the risk of deflation and the need for very low interest rates or other extraordinary measures, such as the Fed's purchasing of Treasury securities, to insure against it. Some in the bond market seem unsure about whether Bernanke's concerns over rising and falling prices are symmetrical.

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They might be in for a surprise. The bond sell-off on the appointment news represents "an uninformed view of Ben Bernanke," says Roger M. Kubarych, senior economic advisor at HVB Group in New York. That's because Bernanke is at least theoretically committed to inflation-targeting. That is, the Fed should adjust interest rates to keep inflation within a given range. By definition, says Kubarych, an inflation-targeter will be just as diligent on the upside of that range as on the downside. Keep in mind that Bernanke, not shy to speak his mind, voted for the Fed's first seven rate hikes without dissenting, before his departure from the board earlier this year.

BERNANKE SOON MAY GET an opportunity to prove his inflation-fighting mettle. In a speech in Chicago in March, the then-Fed Governor forecasted that in 2005 the Fed's preferred measure of inflation -- the price index for personal consumption expenditures excluding energy and food -- would likely remain in what Bernanke called his "comfort zone of 1% to 2%." In August, inflation already stood at his upper limit of 2%, and the expected pass-through of higher energy costs seems likely to push that gauge above 2% by next year.

For one reason, despite the buffeting from higher energy prices and hurricanes, the economy continues to plow ahead. The National Association for Business Economics' latest Industry Survey, taken on Oct. 4-14, shows strong demand, good profit margins, and solid capital spending plans. It also offered more evidence that inflation is on the rise. The net percentage of companies reporting higher prices for both the materials they purchase and the products they sell rose to 38%, the second highest in the survey's 24-year history.

But while Bernanke is committed to the theory of inflation-targeting, he is unlikely to try to rush those ideas into policymaking practice anytime soon. It's not simply that the strategy faces opposition on the Board. It will also be a tough sell to Congress, which has given the Fed a dual mandate, not only to control inflation but also to promote maximum sustainable economic growth. That means Congress is likely to weigh in on any debate over formalizing any targeting scheme, and Bernanke will be careful to protect the Fed's independence.

Already, Senator Paul S. Sarbanes, ranking Democrat on the Senate Banking Committee, which will hold hearings on the nomination, has raised a question on the issue. After Bernanke's pledge to "maintain continuity" with previous policies, Sarbanes told Bloomberg News in an interview on Oct. 24, "How will you sustain continuity when you've enunciated a principle that chairman Greenspan has been unwilling to accept?"

BERNANKE'S ANSWER lies in his framework for inflation-targeting, which he laid out in two speeches in February and March, 2003, a framework that will very likely guide his approach to policymaking. He calls the strategy "constrained discretion." Contrary to most accounts, Bernanke's approach is not a strict rules-based system that says the Fed must pick a target and stick to it come hell or high water.

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As he put it two years ago, "constrained discretion attempts to strike a balance between the inflexibility of strict policy rules and the potential lack of discipline and structure inherent in unfettered policymaker discretion." That means, in case of extraordinary circumstances, the rules can be bent to accommodate the policymakers' best judgment. Bernanke goes so far as to say that this paradigm "describes reasonably well the recent policy approach of the Federal Reserve," except without the publicly announced inflation targets.

The real trick for Bernanke will be to sell his policy ideas to both Congress and the bond market, each with competing priorities. Congress wants assurance on growth and jobs, while the bond market has a cold eye on inflation. In the coming year, both groups will be struggling to get a handle on the balance between how much constraint Bernanke's Fed will enforce in its rate-setting decisions and how much discretion it will allow along the way.

By James C. Cooper & Kathleen Madigan

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