As Ben S. Bernanke takes over as chairman at the Federal Reserve System, the influential federal funds rate is in the middle of what most economists would consider the "neutral zone." However, as he succeeds Alan Greenspan, Bernanke confronts what in essence is a political decision: Does he want the U.S. economy to be weak now and strong in 2008 to enhance the chances of a Republican victory, or does he want it to be stronger this year and weaker in the future?
This year will be a lousy year, and if the Fed continues to tighten monetary policy anyhow, it will cause a more severe slowdown while knocking the stuffing out of inflationary expectations. Under this course of action, the Fed can ease in 2007, and the economy will come roaring back in 2008. (Keep in mind that there is about a one-year lag between changes in Fed policy and changes in the economy.) On the other hand, as signs of the slowdown accumulate, Bernanke may be under increasing pressure to abandon further increases in the funds rate, and as the new kid on the block, no one knows how well he will stand up to that pressure. Especially if the designated headhunters in the Republican Party start sniping at him.
You may -- or may not -- remember G. William Miller, who took over the Fed in 1979. He didn't want President Jimmy Carter to run for re-election in a recession year, so he goosed the money supply soon after taking office. Both he and Carter quickly lost their jobs.
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It is an odds-on bet that Bernanke will be tested early. Wall Street will be probing to see if he will tilt toward accommodation, and even more important, Main Street will be probing to see if they can raise prices. If Bernanke fails to boost the funds rate further during early 2006, stock prices will go up -- for a while -- and inflation will accelerate. Higher oil prices will spill over into the core inflation rate, and the accompanying decline of the U.S. dollar will boost import prices and reduce domestic pressures to hold the line. Eventually the Fed will have to reverse course and tighten a lot more -- which means the economy will slow down in 2008 and the Republican supremacy in Washington will go down the tubes.
I don't give advice to Fed chairmen (not that it would make any difference). But in this case, Bernanke's hand has no hidden cards. He has stressed the importance of transparency and accountability of the Fed. If he acts forcefully and temporarily pushes the funds rate above its equilibrium level, which means at least 5%, the U.S. economy will not perform very well this year, but will recover in 2007 and come roaring back in 2008. But if he waffles, the economy will continue to grow at average or better rates this year, but the outlook will be far worse just in time for the next presidential election.
Michael K. Evans is chief economist for American Economics Group, Washington, D.C., and president of the Evans Group, an economics consulting firm in Boca Raton, Fla. Also see: Economic Outlook and Financial Market Outlook: Mike Evans' new blogs on the economy and stock market.
