How Bernanke would fine-tune the economy

The Fed nominee has called for inflation targets, but he promoted flexibility before senators Tuesday.

Could a computer run the Fed?

That's the essence of a question Federal Reserve Chairman nominee Ben Bernanke once posed in an academic paper. With so many factors affecting the economy, might automated models outperform human judgment in setting monetary policy?

By raising the "man versus machine" query, Dr. Bernanke showed his interest in developing and following clear guidelines - a penchant that could lead the Fed into new terrain if he is confirmed to succeed Alan Greenspan next year.

A central banker's difficult task of balancing rules and flexibility - a task often made trickier by presidential pressure - is a theme Bernanke returned to Tuesday in his confirmation hearing before the Senate Banking Committee.

While Alan Greenspan was seen as running the Fed like an intuitive auto mechanic, assessing the purr and whine of the economy's engine, Bernanke is expected to be more of a textbook mechanic. Yet the distinction, experts say, may prove to be a nuanced one. Both men look closely at economic indicators, and both understand the importance of flexibility in policymaking.

As the world's most powerful banker, Bernanke will be mustering monetary art as well as science, and he knows it.

"People associate inflation targeting somewhat wrongly with rigidity," says Raghuram Rajan, chief economist at the International Monetary Fund in Washington. "His theme as an academic was how to depersonalize this whole process," but not to make it inflexible.

Indeed, although Bernanke has called for the Fed to set specific inflation targets, his answer to the "man versus machine" debate revealed a man not prone to putting the economy merely on autopilot. He and coauthor Jean Boivin concluded in the 2001 paper that man can outperform so-called expert systems. "There clearly remains considerable scope for human judgment about special factors or conditions in the economy," said the two researchers.

For Bernanke, one of the leading experts on monetary policy, confirmation by the Senate appears assured for a term beginning next February. His first task will be to build his credibility in containing inflation and providing the nation with economic guidance independent of political pressures.

Tuesday, the Labor Department reported that wholesale prices jumped by 0.7 percent in October, despite forecasts that wholesale inflation would be flat following a big surge the previous month.

Meanwhile, October retail sales came in stronger than expected, the Commerce Department reported. Excluding automobile sales, which fell sharply, sales of retail goods rose a robust 0.9 percent.

Together, the reports seem to underscore Fed policymakers' current stance that the economy is healthy but that vigilance against possible inflation is needed.

The Fed has been raising its short-term interest rate steadily, by a quarter of a percentage point at each meeting since mid-2004. That short-term rate will probably exceed 4 percent by the time Bernanke would take the helm next year.

Still, the recent rise in both consumer and producer price levels, due largely to rising energy costs, has not driven the so-called "core rate" of inflation sharply upward.

That core rate, which excludes the impact of food and energy on prices, actually fell in October's wholesale report by 0.3 percent, the largest one-month drop in two years.

Against this backdrop, Bernanke used his Senate appearance to promote his goal of formal inflation objectives and of flexibility in Fed policymaking.

"I do not subscribe to any rigid and mechanical rule" for setting interest rates, Bernanke told senators. "I intend to be flexible and to learn from experience."

Citing the Fed's current policy path under Greenspan, he said "the right starting point ... is where we are."

He affirmed not only continuity with Greenspan but also support for the Fed's "dual mandate" from Congress to promote both stable prices and full employment.

The best way to achieve those twin goals, he said, is to maintain low inflation and level expectations about future prices.

He said he would have to build consensus within the Fed before using an explicit inflation target as a tool to reach that goal.

He opened his testimony on another closely watched note: an assertion of Federal Reserve independence from Capitol Hill politics. He said he would not comment on specific tax policies, for example, but said "I agree that budget deficits are a problem."

David Wyss, chief economist at Standard & Poor's in New York, says Fed officials naturally are reluctant at first to weigh in on issues beyond the agency's official mandate. Yet often, over time, they become more willing to opine on such matters.

That can be good or bad, depending on one's view. It can be sometimes be useful, Mr. Wyss says, to have an unofficial economist-in-chief, speaking from a vantage point somewhat removed from politics.

In addition to an economy burdened by rising entitlement costs as baby boomers retire, Bernanke will face other possible challenges - some of which were the subject of questions Tuesday:

• The trade deficit. The nation's balance sheet with the rest of the world is in record deficit territory. Asked if he was alarmed by that, Bernanke simply said the imbalance would have to be corrected over a period of time. For now, trading partners such as China and Japan are willing to hold the dollars they receive from an import-hungry US.

• Housing prices. American consumers have hefty deficits of their own, often tapping lines of credit based on home prices that have risen in recent years. Now, as the Fed raises interest rates, the housing market appears to be softening. Amid concerns about a real estate "bubble" in parts of the US, "the Fed won't cry if home prices flatten," Wyss says. But the process could put a damper on consumer spending.

• Financial markets. Some experts say a long era of low and stable interest rates may have created an environment where private-sector financiers have become complacent about some of the risks they take. The results could be big losses by financial companies that show up only during an economic downturn.

"If the economy turns down we may have more severe credit problems," says Dr. Rajan of the IMF. He says it's not clear how big these risks are, but in his view, the Fed should be watchful in its role as a regulator of the financial sector.

Fed chiefs in the past have often faced significant tests early in their tenure.

Consider Greenspan: "Within two months he had a stock market break, which in one day wiped out about one quarter of the value of the stock market," says Allan Meltzer, an economist and historian of the Fed at Carnegie Mellon University in Pittsburgh.

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