To date, the markets haven't known quite what to expect from new Fed chairman, Ben Bernanke. With his first public appearance last week, there's more to go on.
How have the markets reacted to Bernanke?
With approval. Last week, in his first public appearance since taking over from Alan Greenspan (who held the post for 19 years), the new chairman of the US Federal Reserve dispelled fears that he might prove more tolerant of inflation than his predecessor. In 2003, Bernanke alarmed the bond markets with a speech arguing that the US Fed should drop dollar bills from a helicopter to stave off the threat of deflation, something he has often said he considers to be a much worse evil than inflation. But in a two-day grilling from the US Senate, Bernanke made clear that he would be vigilant about inflation. The markets duly priced in two further interest-rate hikes for this year, in March and May, which would take rates to 5%.
Does the US have an inflation problem?
Not at the moment. The core rate of inflation the number the Fed is thought to watch most closely is currently 1.9%, within the 1%-2% range that Bernanke is thought to consider appropriate for the US economy. But this measurement does not include food and energy prices, both of which have risen. So far, there is little evidence of so-called "second-round" effects, with higher energy prices feeding through to a higher core inflation rate. But with the US economy now running at close to full capacity, with unemployment low, retail sales booming and factory output strong, there are still concerns. Indeed, in 2005 the Consumer Price Index rose 3.4% and in January the Producer Price Index core rate (which also excludes food and energy) rose 0.4%, the fastest rate in a year. The trick now is to stop the US economy over-heating.
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How close is the US economy to over-heating?
That depends partly on what you think is happening to the housing market. US house prices have been rising by about 10% a year over the last few years and much faster in some parts of the country. In January, the number of houses on which construction has been started was at its highest in more than 30 years, according to official figures. That's fuelled talk of a housing bubble, which has triggered a consumer boom as people borrow against their rising household wealth. Some argue Bernanke needs to raise interest rates fast in order to bring a swift end to this house-price inflation. Left unchecked, they fear the bubble will eventually burst, leading to a collapse in consumer spending, and possibly even a recession.
Does Bernanke share this view?
No. He's sanguine about the threat of a house-price crash. He thinks there will be a gentle levelling down instead. In his evidence to the Senate last week, he backed up these claims with evidence that houses are already taking longer to sell than they were and that prices of new homes are already falling. What's more, low mortgage rates, a tight labour market and rising incomes should be enough to prevent a hard landing, as they appear to have done so far in the UK and Australia. Bernanke is therefore less worried about house prices than about ensuring the US economy does not exceed its trend rate of growth the rate at which it can grow without triggering inflation.
So how fast can the US economy grow?
The Fed reckons the trend rate of growth is about 3.5%, but some economists question this assumption. They point out that in a global economy, countries sub-contract production overseas. As Fed governor Richard Fisher said in a speech last November: "How can we calculate a US output gap without knowing the present capacity of, say, the Chinese and Indian economies?" It is this emerging-market excess capacity that has allowed the global economy to grow so fast over the last few years and absorb huge energy-price hikes without triggering inflation. Indeed, Janet Henry, global economist at HSBC, reckons the global trend growth rate is more like 4% and that for every 1% above this level that the global economy grows, US inflation rises 0.5%.
And will that growth pose an inflationary risk?
Not according to the Fed. And if Henry is right, global economic growth, which currently also stands at 3.5%, is still some way below a level at which it poses an inflationary risk. True, the rapid growth of domestic demand in China, the recovery in Japan, growing demand from oil-rich Russia and Middle Eastern countries, is absorbing a lot of global capacity and will one day pose an inflationary risk. Much of this global boom is the legacy of Greenspan's own policies of keeping interest rates very low all through the 1990s and throughout the early part of this decade. One day, Bernanke will have to deal with the long-term fall out from this easy-money legacy but, it seems, not quite yet.
How Bernanke will differ from Greenspan
Since his appointment, Bernanke has been keen to use his public appearances to emphasise that his intentions are simply to continue the policies of his predecessor. That was only to be expected, given Greenspan's legendary status in the markets. But observers have already noted that Bernanke is not quite the same as Greenspan: he is, for example, more willing to give a direct answer than the notoriously Delphic Greenspan. Over time, Bernanke is also thought to be likely to introduce other changes, including a formal inflation target. He hinted at this in his Senate testimony when he explained why it was correct for the Fed to focus on inflation as a means of achieving its broader mandate. But this is not something he will rush into.
Simon Nixon is executive editor of Breakingviews.com
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