The watch list for the next Fed chairman

By , Staff writer of The Christian Science Monitor

When Ben Bernanke takes control of the Federal Reserve as expected this week, he will have to get off to a brisk start. Among the challenges awaiting him:

• The cost of living is probably running a little higher than the inflation-fighter would like, prompting the question: When should he stop raising interest rates?

• With growth slowing dramatically last quarter, some worry that it could evaporate by 2007. If it does, should he stop raising interest rates sooner rather than later?

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• Almost every new Federal Reserve head in modern times has had a crisis hit shortly after taking over the helm. Will history repeat itself?

Yes, as long as the Senate confirms Mr. Bernanke as the 14th Fed chairman, he will certainly get the opportunity to earn his $180,100 salary. He'll have to grapple with the effect on the economy of 13 interest-rate hikes (with the 14th expected Tuesday). By the end of March, he will have to decide whether to keep tapping the brakes on the economy. And through the year, he'll have to keep an eye on energy prices and other potential pocket-busting increases in the cost of living.

Overall, he will be concerned about how the markets perceive his actions. "New Fed chairmen like to come out of the gate looking hawkish as they try to formulate their credibility," says Anthony Chan, an economist at JPMorgan Asset Management in Columbus, Ohio. "Then, they go back to looking more dovish."

Bernanke is likely to display his hawkish side when he looks at the inflation rate. The chairman nominee is an adherent of "inflation targeting" - the setting of a numerical goal for the consumer price index or a similar gauge of the cost of living.

Last year, the consumer price index, not counting food and energy, rose at a 2.2 percent annual rate - a pace that is close to optimal. Including food and energy, prices rose by 3.4 percent. In fact, according to the Bureau of Labor Statistics, the cost of household fuels rose 18 percent and the cost of motor fuel 16 percent.

"Bernanke's big challenge is these stubbornly high energy prices," says Mr. Chan. "The more they persist, the higher the probability of more and more of them spilling over eventually into other areas."

But what can the Fed chairman do to affect the price of a barrel of oil, a commodity that can rise and fall on rumors and incomplete information? "He has control over how he reacts to the high energy prices," says Chan. "As far as it affects inflation, he might use monetary policy as a blunt tool."

Cautious approach to changes

Still, longtime Fed watchers think Bernanke will be cautious in making any changes in the Fed's decisionmaking process. "He is enough of a policy wonk to know that how you make change is very, very important," says Bob Brusca, an economist who worked at the New York Federal Reserve. "They will run models and simulations."

If the economy slows further, getting Fed policy just right will be crucial since there may not be much margin for error.

One key measure Bernanke may look at is something called the "sacrifice ratio" - the trade-off between unemployment and inflation when Fed policy changes, says David Kotok, an economist and chairman of Cumberland Advisors in Vineland, N.J. "How much additional unemployment over a period of time does the Fed have to impose to drop an inflation rate," says Mr. Kotok.

"If the sacrifice ratio is high, and the Fed believes it's an accurate estimate, then the Fed must have a bias," he says. A bias would mean higher short-term interest rates than if the ratio were low.

The importance of the current high ratio, says Kotok, is that it shows that the nation's central bank can't afford to let inflation get out of control because the cost of reining it in will be many Americans losing their jobs. For this reason, he believes Bernanke's Fed will be very slow to cut interest rates even if the economy slows significantly in 2006.

Although most recent incoming Fed chairmen have aimed to keep inflation in check, they have also had to show some flexibility, especially in their early days. Arthur Burns (1970-78) faced a dollar crisis. Paul Volcker (1979-87) took over with inflation fires burning and quickly raised interest rates, prompting a bond-market meltdown and a recession. Within three months of taking over from Mr. Volcker, Alan Greenspan faced a stock-market crash.

Mr. Greenspan reacted to the crash by letting the markets know the Fed would provide liquidity. He did the same after the terror attacks of 9/11.

Bernanke may be tested as well, says Lynn Reaser, the Boston-based chief economist at the Investment Strategies Group at the Bank of America. "It could take a variety of forms - a terrorist attack, or a major problem at a financial institution or fund, or a precipitous drop in the value of the dollar, or some other trigger causing a massive shrinking of liquidity in the financial markets," says Ms. Reaser.

Job numbers due this week

However, at the very beginning, Bernanke's time is likely to be spent on more mundane matters: This Friday, the government will report the January employment numbers and the unemployment rate.

This will give him some clues about the strength of the economy as it moves deeper into the first quarter. "The unemployment rate is the bigger focus for the Fed right now," says Scott Brown, chief economist at Raymond James & Associates in St. Petersburg, Fla. "One of the concerns at the Fed is tightness in the labor markets," he says, noting that in Florida the unemployment rate is down to 3.3 percent.

Only a few weeks later, Bernanke is slated to appear before Congress to talk about monetary policy. "He'll be speaking for the Fed as a whole, not for Ben Bernanke," says Mr. Brown. And it could be one of his first chances to talk about the challenges ahead.

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