For U.S. Federal Reserve Chairman Ben S. Bernanke, the biggest challenges are still to come.
U.S. President Barack Obama yesterday (Tuesday) nominated Bernanke for a second four-year term as chairman of the U.S. Federal Reserve. The appointment was mildly controversial and must be approved by the Senate, but lawmakers and investors overwhelmingly approved of the decision to the central bank chief who has shepherded the U.S. economy though its worst financial crisis in more than 70 years.
Bernanke has been criticized for greatly expanding the powers of the U.S. central bank by bailing out large financial institutions like American International Group Inc. (NYSE: AIG) and The Bear Stearns Cos. - while letting Lehman Bros. Holdings Inc. (OTC: LEHMQ) collapse. At the same time, however, ambitious Fed programs designed to recapitalize banks and unfreeze credit markets have succeeded.
"Ben Bernanke, has led the Fed through the one of the worst financial crises that this nation and this world have ever faced," said President Obama. "As an expert on the causes of the Great Depression, I'm sure Ben never imagined that he would be part of a team responsible for preventing another. But because of his background, his temperament, his courage, and his creativity, that's exactly what he has helped to achieve."
Of course, that doesn't mean Bernanke's greatest challenges are already behind him. Over the next few years, the Fed chairman will have to unwind the programs he set in place to backstop the markets - such as the Commercial Paper Funding Facility - which holds $109.2 billion in short-term IOUs issued by corporations - and the Term Asset-Backed Securities Loan Facility (TALF) - which has lent $25 billion to investors to buy securities tied to auto and other consumer and business loans.
In all, Bernanke has injected more than $2 trillion into the U.S. financial system. He's also lowered the Federal Reserve's benchmark lending rate to a record low range of 0.00%- 0.25%.
As a result, the U.S. monetary base has about doubled during the past two years.
Earlier this month, Bernanke said that the central bank's program to buy U.S. Treasury securities would be shut down by the end of October. He's also pointed out that some of the Fed's emergency lending facilities automatically wind down as the economy recovers, because they have onerous pricing and terms.
The central bank could undertake two key steps to accelerate that whole process. It could:
- Increase the amount of interest paid on balances held at the Federal Reserve by depository institutions (banks).
- Sell securities from the Federal Reserve's portfolio with the agreement to buy them back at a later date.
However, Bernanke has provided very few clues about what his so-called "exit strategy" will involve, or how it will be implemented. That is, at what point will inflation become enough of a concern, and at what point does U.S. growth become sustainable enough, to warrant a change in Fed policy?
And that could easily prove to be Bernanke's next big challenge.
At some point, Bernanke will have to raise the Fed's benchmark rate from its current record low range. But it's almost a classic Catch 22: Doing so too soon could stall the fragile U.S. economic recovery; waiting too long to boost rates could allow ruinous inflation to take hold, resulting in a major spike in the cost of food, energy and other essentials.
In this sense, "policymakers are damned if they do and damned if they don't," said Nouriel Roubini, a professor at the Stern Business School at New York University who is often credited with predicting the financial meltdown.
"If they take large fiscal deficits seriously and raise taxes, cut spending and mop up excess liquidity soon, they would undermine recovery and tip the economy back into stag-deflation (recession and deflation)," Prof. Roubini said. "But if they maintain large budget deficits, bond-market vigilantes will punish policymakers. Then, inflationary expectations will increase, long-term government bond yields would rise and borrowing rates will go up sharply, leading to stagflation."
Part of the reason Obama is seeking to reappoint Bernanke is that another Fed chairman could disrupt the markets if he or she were to deviate from the path Bernanke has set.
"Wall Street can breath a little easier," Christopher Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. (NYSE ADR: MTU), told Bloomberg News. "Having a new chairman come in at this late date would put the Fed-engineered solution to both the recovery and the exit strategy at risk."
Government officials told reporters that White House Chief of Staff Rahm Emanuel, U.S. Treasury Secretary , and National Economic Council Chairman Lawrence H. Summers all recommended that Obama reappoint Bernanke.
And Summers, the former president of Harvard University, had been the leading candidate to replace Bernanke as chairman of the Fed.
Bernanke's Political Challenges
Putting the economy back on the path to solid and sustainable growth won't be Bernanke's only task, either. In the years ahead, he will have a large role in the Obama administration's push to overhaul financial market regulation.
"Looking forward, we must urgently address structural weakness in the financial system, in particular in the regulatory framework, to ensure that the enormous costs of the past two years will not be borne again," Bernanke said earlier this week.
Obama's plan puts Bernanke and the Federal Reserve in an awkward position. The plan broadly expands the central bank's authority in dealing with systemic risks - such as the growth of reckless mortgage lending or the misuse of financial derivatives - by essentially giving the central bank the power to oversee from top to bottom almost any financial company in the country, including a firm's foreign affiliates.
However, that would make Bernanke an even bigger target for members of Congress who believe the Fed already has too much power, and was far too cozy with banks and Wall Street firms as the mortgage crisis was building.
"Why does the Fed deserve more authority when institutionally it seemed to have failed to prevent the current crisis?" U.S. Sen. Christopher J. Dodd, D-CT, asked last month.
It's possible that Bernanke will face similar questions at his upcoming confirmation hearing.
"I expect many serious questions will be raised about the role of the Federal Reserve moving forward and what authorities it should and should not have," Sen. Dodd told The Wall Street Journal yesterday.
Despite these concerns about the expanding authority of the Fed, Sen. Dodd did support Bernanke's reappointment.
"While I have had serious differences with the Federal Reserve over the past few years, I think reappointing chairman Bernanke is probably the right choice," Dodd said. "Chairman Bernanke was slow to act during the early stages of the foreclosure crisis, but he ultimately demonstrated effective leadership and his reappointment sends the right signal to the markets."
It was Bernanke's slowness to act early on that may actually cost the Fed some of its powers. While Obama's plan generally increases the role of the Fed, it also calls for the creation of a new, independent regulatory agency. That agency would write rules related to mortgages, credit cards and other consumer products, taking away powers previously held by the central bank.
Bernanke has acknowledged that the Fed underestimated the seriousness of the financial crisis at the outset - including the danger posed by subprime mortgage lending - but remains reluctant to relinquish the Fed's role as a consumer advocate.
"We think the Fed can play a constructive role in protecting consumers," Bernanke told members of the House Financial Services Committee last month.
Indeed, Bernanke's response to the financial crisis - and what he does to keep the U.S. economy from relapsing - will play two vital roles: It will shape Bernanke' s financial-crisis legacy; and it will help determine the future role of the Federal Reserve.
"This last couple of years has been clearly a move through uncharted territory, and as we've seen it's taken a lot of unconventional moves to try to deal with the situation," Robert Parry, former president of the San Francisco Fed, told Bloomberg. "There's been a lot of innovation that's gone on, and it seems to me that much of it has been successful."
[Please click here for a commentary analysis of Bernanke's reappointment by Money Morning Contributing Editor Martin Hutchinson.]
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