The reaction to the nomination of Ben Bernanke to head the Fed has generally been positive. Not being a monetarist, I’ll decline to comment on his inflation-fighting qualifications — other than to note that by law the fighting inflation is only part of the Fed’s job. There are two prime goals for monetary policy: promoting full employment and promoting stable prices. The Fed is also the guardian of the stability of the banking and monetary system.
Which leads me to Stephen Roach’s comments in the LA Times, “The ambush waiting for Bernanke”:
Bernanke is widely thought to be the perfect central banker to cope with this problem. He is renowned for his skills as an inflation fighter. He has led the charge in the academic debate over “inflation targeting” — arguing that a central bank needs to be explicit in aligning its policy instrument (the federal funds rate) with a numerical target of price stability (a 1% to 2% increase in the “core” consumer price index).
But I suspect that the current inflation scare will turn out to be a false alarm. As always, energy prices will come down when demand sags — some of that may already be occurring — and the new and powerful forces of globalization should continue to hold other prices largely in check.
The U.S. economy actually faces far greater threats than inflation — threats that an inflation targeter such as Bernanke may be ill-equipped to deal with.
At the top of the list is a record U.S. current account deficit — the broadest measure of the nation’s trade balance (imbalance, in this case) with the rest of the world. Running at an annual rate of close to $800 billion in the first half of 2005, it requires foreign funding to the tune of $3 billion per business day. To accomplish that without a sharp drop in the dollar and/or a related backup in interest rates requires extraordinary confidence on the part of foreign investors in U.S. assets.
The foreign confidence factor could well be Bernanke’s biggest challenge when he takes the reins at the Fed. The nation’s current account deficit averaged just -1.5% of gross domestic product at the three most recent Fed transition points — the ascendancy of Miller, Volcker and Greenspan.
By contrast, today’s deficit is more than four times larger at -6.4%. Moreover, in the face of an energy shock and a post-Katrina fiscal spending binge, there is good reason to look for a further reduction in U.S. saving and a related widening of the current account deficit over the next year.
In short, the U.S. is going to be asking a lot more of the foreign investor at precisely the moment the Fed is transitioning from Greenspan to Bernanke. As the maestro leaves the building, the hard-won aura of foreign confidence that surrounds him could be quick to follow. Bernanke could be faced with a dollar crisis and the related need on the part of foreign investors to seek compensation for taking currency risk. That compensation invariably spells higher interest rates — the last thing the nation’s housing bubble and overly indebted consumers need.
I’m not sure I agree that higher interest rates are necessarily bad. But I do agree that the Feds decisions are likely to revolve around reactions to what foreign investors do. Our huge current account deficit makes that an inevitability.
Welcome to what might be the toughest job in Washington, Dr. Bernanke!