October 24, 2005, 3:03 p.m.
Bernanke Pros, Cons, and Intangibles
Our next Fed chair may keep us guessing well into next year.

By Michael T. Darda

President Bush confirmed a fury of media speculation Monday when he nominated Ben Bernanke to replace Alan Greenspan as chairman of the Federal Reserve. The market reaction was consistently upward; gold, bond yields, and equities all rose on the news. This likely means that a worst-case scenario has been averted, but uncertainties remain.

Anyone who has even casually paid attention during the Greenspan years knows that this is an important post. Assuming that Bernanke is confirmed by the U.S. Senate, he would begin his Fed chairmanship on February 1, 2006. (Greenspan’s term expires on January 31, 2006, which happens to correspond to the Fed’s first rate-setting meeting of the new year). Up until this point, my hope was that Vice President Dick Cheney’s influence on the nomination process would tip the scales toward former Council of Economic Advisors chairman Glenn Hubbard, a pro-growth stalwart on fiscal policy. Bernanke, however, an academic with little Wall Street experience, was the favorite, and was probably viewed as the safest option for the administration.

It’s likely that the key federal funds interest rate will be at 4.5 percent when Greenspan relinquishes the chairmanship to Bernanke, which means in all likelihood that the Fed’s tightening effort will be close to complete. This takes a certain degree of pressure off Bernanke, but it doesn’t tell us much about how Bernanke will monitor price-level pressures after that. I preferred Hubbard to Bernanke only because I thought Bush’s former CEA chief would be more open to a price-rule approach to monetary policy, whereby the Fed would shadow sensitive forward-looking indicators of excess liquidity and incipient inflation: gold, commodities, the dollar, and the Treasury yield curve (and perhaps the TIPS spread and the real short rate).

While I’m told that Bernanke is open to market indicators, he also seems overtly committed to an explicit target for the core inflation rate, which I view as problematic. Trying to stabilize a backward-looking index of prices by manipulating short rates probably is an impossible task, not to mention an undesirable one. Most core inflation indices lag the Fed’s monetary actions by no less than 18 months, which means that responding to a price index reflective of the stance of monetary policy more than a year prior would be like running through an obstacle course backwards and blindfolded. Doing so wouldn’t prevent a hard landing — it would ensure it.

I also have some concern about Bernanke’s view of the inflation process, which seems to be driven by different measures of “slack” in the economy instead of indicators of excess liquidity, which is explicitly under the control of the Fed. The slack-based approach is embraced by many Reserve Bank presidents and Fed governors, and is also favored in academic circles.

The term “slack” simply means how much the economy is growing below or above its historical average or some measure of its potential. It is a variant of the Phillips curve, which asserts that inflationary pressures are the result of employment levels, wage pressures, capacity utilization rates, and the deviation in output from trend and asset values. I don’t like this model because the empirical linkage between growth and inflation is non-existent, or inverse, while the relationship between unemployment and inflation is significant and positive. The data clearly show that inflation raises unemployment with a lag, precisely the opposite of the original precept of the Phillips curve. Wage pressures and capacity constraints can result from excess liquidity and thus be positively associated with inflation, but on their own they have no power to raise the dollar price level without the accomplice of excess money.

Inflation is a monetary phenomenon, not a cost-push event.

Bernanke may very well find some role for leading market indicators, perhaps fusing them with his idea of a stable zone for core inflation. And then again, maybe he won’t. I’m more confident that chairman Greenspan will want to have most of the rate-hike heavy lifting out of the way by the time Bernanke assumes the Fed chair.

If the Fed tightens at each of the next three meetings prior to the expiration of Greenspan’s term on January 31, 2006, the fed funds rate will stand at a level that could be considered neutral. However, I have yet to see the whites of the eyes of the core inflation climax likely to stem from the Fed’s excessive accommodation during the last few years. If the funds rate has been hoisted to a neutral level by the time core inflation is peaking (perhaps during mid-to-late 2006 at the earliest), the new Fed chairman will have to choose between sensitive indicators or overshoot. This may turn out to be Bernanke’s first big challenge.

— Michael T. Darda is the chief economist and director of research for MKM Partners, an equity execution and research boutique located in Greenwich, Conn. He welcomes your comments here.