Hamish McRae: Bernanke's appointment is a good one, but he will certainly face a few shocks

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The Independent Online

So far so good. What the markets know of his background is broadly encouraging. He is a serious professional economist who has written extensively about the big idea of central banking in the 1990s, inflation targeting. He has a sense of history, knowing a great deal about the depression of the 1930s, warning about the dangers of that happening again, and able to see the possible parallels between the present and past experiences.

In that sense, his background straddles the two seminal monetary experiences of the 20th century. The depression saw the sharpest decline in prices in the US for at least two centuries and the great inflation of 1970 to 1990 saw the greatest rise in prices that has occurred in the US (and the UK) in recorded history.

The hardest thing for central bankers at the moment is to know which bit of monetary history is most appropriate as a guide: how should we see the present, without being overly influenced by either of these horror stories. So you want someone who understands it.

So how will he perform? Unsurprisingly people have been combing over his background, what he has said on various occasions, what his colleagues and former colleagues think and so on. This is not really very helpful because of all the jobs in the world, this is one where the incumbent grows in office.

Both Paul Volcker and Alan Greenspan are regarded quite differently from the way they were seen when they were appointed. People were worried whether Mr Volcker would indeed be able to conduct the great task of crushing US (and hence global) inflation after the two oil shocks of the 1970s. When Dr Greenspan was appointed people were concerned that he might be too political: a Republican appointment. Now both are seen as great figures.

It is more helpful to look first at the particular known problems that the new chairman will face and then at possible responses to them.

The Fed has been unusual in the world of central banking in that it has not had an inflation target. We have had one since 1992, the European Central Bank has one - indeed most of the developed world now operates on this discipline, though the earlier favourite tool of the central banks, monetary targeting, is still to some extent in use.

Inflation targeting has weaknesses. In particular, if it just covers current inflation, the rise in the price of goods and services, it will not take into account asset inflation, the rise of the price of shares and property. Thanks to the growth of low-cost manufacturing from China and, to a lesser extent, low-cost services from India, current inflation has remained low everywhere, at least until recently. Asset inflation, and in particular the rise in property prices, is a serious concern in many countries, including the US.

Nevertheless inflation targeting is the global standard and the US is not on it. The interesting question is whether, had it had such a target, policy might have been different. Might the Fed have leaned harder against the excesses of the dot.com boom? Might it have been quicker in increasing rates in the present cycle? Looking ahead, might the US be under pressure to adopt inflation targets in the future?

For the US certainly does have an inflation problem and a more serious one than the rest of the developed world. But it is hard to know quite how worried to be about this. You can see the dilemma in the first and second graphs. Core inflation - that is ignoring seasonable and variables - fell through the 1990s, picked up a bit around 2000, and then fell again. True, it has come up a little but it is still benign. The headline rate, on the other hand, looked all right until the middle of this year but now, thanks to the surge in oil prices, is not benign at all. Inflation by the end of this year is going to be about 5 per cent, the highest in the developed world.

That raises the obvious question: suppose fuel prices remain high? Maybe the headline rate matters more than the core. Moreover, the reasonable performance of core inflation has been to a large extent the result of cheap goods, mostly imported, or at least squeezed down by imports. But that may be less strong a force. Goods prices were sharply negative two years ago but now are positive again (second graph). Meanwhile, the price of services keeps rising. Markets ought to take more account of core prices than headline ones, but if the headline rate of inflation is 5 per cent it will be very hard for the Fed not to keep upping interest rates. Barclays Capital's forecasts are shown in the bar chart. These show another two quarter-point increases in the Fed funds rate (the key rate controlled by the Fed) before the end of the year, and another two in the first three months of next year, to 4.75 per cent.

If the Fed is seen to have "done enough" then long-term rates should remain benign: that is implicit in those forecasts for 10- and 30-year rates. And if there is no surge in long-term rates, then the US housing market might manage a soft landing similar to the one we seem to be having in the UK. But you can see the issue: will Dr Bernanke be able to maintain the confidence of investors, international as well as US, as well as his predecessor, during an inevitably difficult time?

That is the known and immediate problem, the first test. Others will follow. The most obvious of these will be associated with the US current account deficit, now close to 6 per cent of GDP. Everyone knows something will happen but none of us can call the timing or the pace of change.

In the past, markets, when confronted with something they find unacceptable, have staged a riot. That happened to sterling in 1992. It could happen to the dollar, though I think that unlikely. A gradual shading down is more probable than a crash. But Dr Bernanke will have to maintain confidence through the end of the expansionary phase of the current global cycle which, on past form, will come in about three years. The US current account deficit will be a key element in the next downturn. That sounds a bit glum. It is not meant to be.

The point is simply that all our past experience tells us that there will be shocks to the world economy in the near future, and much bigger ones than the present run-up of oil prices. Quite aside from macroeconomic pressures there will, on past form, be some kind of financial crash - probably several crashes - during Dr Bernanke's term of office. The task of the world's central bankers will be to maintain confidence through these difficulties, for they are in the front line of defence. Everything we know about this appointment gives encouragement. But I don't think Dr Greenspan has bequeathed him a particularly easy legacy.

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