Business | Features
Reason to celebrate
At the one year mark, US Federal Reserve chief Ben Bernanke has positioned the economy for a soft landing despite a rocky start
- By Krishna Guha and John Authers, Financial Times
- Published: 00:00 February 6, 2007
Things are looking up for Ben Bernanke, who took his seat at the great oval table in the Federal Reserve boardroom last week for the concluding session of its January policy meeting [where he held the interest rate at 5.25 per cent]. Last week also witnessed the first anniversary of his chairmanship and the news from the markets is good.
Reports prepared by the New York Fed and the Fed's monetary policy division in Washington show that in the past few weeks the bond market - which had been starkly at odds with the Fed over the outlook for the US economy - has thrown in the towel and largely fallen into line with the Fed's more optimistic view on growth.
The same reports show that market measures of long-term inflation expectations, which spiked up alarmingly in his early months on the job, are lower today than they were when Bernanke came into office, a sign that investors no longer doubt his inflation-fighting resolve.
Indeed, the consensus view among Wall Street economists now is that the US economy is heading for a soft landing this year, with growth moderately below trend and receding inflation, a story the Bernanke Fed has been telling for some time.
Risks remain and it will be many months before we know for sure whether the Fed chairman made the right calls in his first year on the job. But at this juncture, says Bob Di Clemente, chief US economist at Citigroup, "Bernanke and company look pretty smart".
Yet the past year has been anything but plain sailing for Bernanke, who even now earns only grudging respect from many market participants. In part this reflects lingering anger at communications problems in his first few months as Fed chief, which traders blame for wild swings in bond prices.
The new chairman took over at a very tricky moment, towards the end of a long series of steady interest rate increases during which the Fed gave an unusually high degree of guidance on where rates were headed. The Fed was no longer sure how much further it would have to go. Bernanke's job was to guess when to stop raising interest rates: to stop too early would have spurred inflation, while to set them too high could have put the US economy into a tailspin.
Investors, though, had come to rely on Fed guidance. Bernanke had to wean them off it at precisely the moment they were trying to get to know him and craved clarity on when the rate hikes would stop. "He had a couple of false starts," says Jim Cusser, portfolio manager at Waddell & Reed. "I think that, as an academic, he was surprised at how seriously his comments were taken by the market."
Bernanke's troubles began a couple of months into the job in April, when he told Congress the Fed might pause its interest rate tightening cycle. At that moment inflation picked up, leading some in the market to doubt the new chairman's commitment to stable prices. To make matters worse, a few days later, CNBC anchorwoman Maria Bartiromo announced during afternoon trading in New York that the Fed chief had told her the market had misinterpreted his testimony.
David Rosenberg, chief US economist at Merrill Lynch, commented then: "We are not sure what to make of the fact that we find out from a reporter about comments that the Fed chairman made at a dinner two days earlier."
Faltering confidence
The price of ordinary bonds started to fall relative to bonds indexed against inflation, a tell-tale sign of faltering confidence in a central bank. Bernanke knew he had to prevent the expectation of higher inflation becoming embedded in bond market prices and public opinion. If that happened, higher inflation would get locked in.
He was forced to slap down rising inflation expectations with a hawkish speech which - accompanied by an echo-chamber of similar comments from other Fed officials - eventually led some investors to fear the Fed would go too far in raising rates.
For a market long used to the opaque Delphic utterances of Greenspan, Bernanke's plain speaking came across at first as shouting in a library. It was not until his July testimony to Congress that Bernanke managed to get a balanced message across.
"He got off to a rocky start," says Allan Meltzer, a professor of economics at Princeton. "But he recovered, things worked out for him."
Edward Gramlich, a former Fed governor, says that for all the furore over communications, the big decision Bernanke had to make last year was how far he had to raise rates to regain control of inflation, without killing growth. Back in the spring, the market worried about the economy overheating. Opposing this was the Fed's own staff analysis, which suggested that housing was already starting to slow and the inflation spurt was largely attributable to temporary factors.
The crunch point came at the August meeting of the Federal Open Market Committee (FOMC), which sets interest rates. Some members - including Janet Yellen, president of the San Francisco Fed - argued for a pause in interest rate increases, based on the analysis that the economy was cooling off; several others - including Jeff Lacker, president of the Richmond Fed - pushed for another rise to hammer down inflation expectations.
The minutes say it was a "close call". People at the table that day say Bernanke could have swung the decision either way: a rate hike might have been the easy option for a new Fed chairman whose credibility had been mocked by some in the market.
But Bernanke's decision to pause was a sign both of his undisturbed self-confidence and his reluctance to inflict unnecessary pain on the economy as a short-cut to gaining market respect. By late summer the bond market had changed its mind about the economy and market measures of expected inflation eased as the housing market shuddered to a sudden stop.
Since then the market has not challenged Bernanke's commitment to fighting inflation. Yet through the autumn and winter of 2006 the market took a much more bearish view on economic growth, and bond prices rose as the market priced in aggressive Fed rate cuts in 2007. "There was an extraordinary divergence between the market and the Fed," says Larry Meyer, a former Fed governor, now chairman of Macroeconomic Advisers. Rather than try to burst the market bubble, Meyer says: "The Fed did not get excited, it kept its rhetoric steady and let the market converge as the data moved in its direction".
Oil prices
This time Bernanke had some good luck. Oil prices tumbled, giving consumers a sudden windfall that helped support spending. Finally, after a run of strong economic data at the end of the year, bond prices fell, largely closing ranks with the Fed.
At the one-year mark, Bernanke is looking increasingly assured. Already, the cerebral former Princeton academic is putting his own stamp on an institution long dominated by his predecessor.
Top serving and former Fed officials interviewed by the FT on the condition that they would not be quoted say Bernanke has fostered a more collegial approach to decision-making. Old hands recall that during policy discussions
at the FOMC Greenspan used to tell the committee what he thought the Fed should do, before asking for comments from others. The rest of the committee, they say, generally saluted.
In contrast, Bernanke speaks last, waiting to see what the other committee members have to say before making his own recommendation. Most meetings now run for two days rather than one, allowing for discussion of longer-range issues. The result is more substantive discussion of the immediate policy decision and greater willingness to alter the draft statement circulated before the meetings begin.
With many new faces around the FOMC table, it has the feel of a new era. But monetary policy is conducted in essentially the same way as before. The main difference is that Bernanke sees value in sharing more texture as to the Fed's outlook on the economy with the market. Fed statements now include more forward-looking language about growth and inflation, as do the chairman's speeches. Larger changes may loom. Shortly after taking over as Fed chief, Bernanke commissioned a far-reaching review of Fed communications strategy, which wraps up in the summer.
Bernanke almost certainly believes the choppy experience of the past year shows the Fed would be better off stating its intended rate of inflation in the form of a flexible target. Currently the market does not know what rate of inflation the Fed is targeting, or the timeframe in which it intends to get there.
Meanwhile, many Fed watchers are troubled by the mood of economic populism abroad in the US. Barney Frank, the new Democratic chairman of the House Financial Services committee, rattled some nerves early this month when he warned against people who thought the Fed should be above democracy.
Not all agree, though, that the relationship between the Democratic Congress and the Fed will be problematic. "There is a little truth to that, but only a very little," says Alan Blinder, a former Fed governor now at Princeton.
Bernanke's biggest challenge in his second year at the Fed, though, will be to achieve the desired soft landing - which the bond market (judging by the higher interest rate on short-term than on long-term bonds) still thinks is far from guaranteed - and to build his credibility with the remaining sceptics in the financial community.
The Fed chairman is still not seen by everyone in the markets as a truly authoritative figure in the mould of Greenspan or Paul Volcker, the previous Fed chairman. Cusser of Waddell & Reed says: "There is a sense that he is more of an academic than a policymaker, and that he is yet to be tested under fire."
To a large extent, Bernanke remains under the shadow of his predecessor, who after 18 years as Fed chairman had built a cult-like following in the markets. "Greenspan earned guru status and with his obfuscation kept the market mesmerised," said David Ader, head of bond strategy at RBS Greenwich Capital.
"Bernanke is a throwback to a more traditional Fed chairman: smart, dull and straightforward. He has had no crisis to deal with."
Marc Chandler, foreign exchange strategist at Brown Brothers & Harriman, observes: "The market has still not gotten the kind of respect for him that I would have imagined. He's looking quite smart at the moment but the market has been brought round to that view only belatedly, kicking and screaming."
In the end, absent the opportunity to score a spectacular touchdown by mastering a crisis, Bernanke will have to win the market's respect the hard way, yard by yard, by continuing to make the right policy calls.
Says Meyer of Macroeconomic Advisers: "There are a lot of people who lost money in the market because they did not pay more attention to what Bernanke was telling them. Nothing teaches respect like losing money."
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