Challenges ahead for US economy


Richard Moore

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Challenges ahead for US economy
By Steve Schifferes 
BBC News economics reporter

Many people may not know the name Ben Bernanke. But at the end of January he 
becomes the world's most powerful central banker when he succeeds the respected 
head of the US Federal Reserve, Alan Greenspan.

    Current job: Chairman, Council of Economic Advisors 
    Former job: Professor of Economics, Princeton 
    Strength: Outspoken advocate of inflation targeting 
    Weaknesses: Limited political experience

During Mr Greenspan's long term in office, he was considered by the financial 
markets as a key guardian of the health of the economy, and his often-enigmatic 
comments were closely watched for signs of his future intentions.

Mr Greenspan was widely applauded for keeping the US economy growing during the 
boom of the 1990s, and for managing the crises of the crash and the 9/11
attacks while keeping the wider economy intact.

Mr Bernanke, a Princeton economist who was only appointed chairman of the 
council of economic advisors in June, faces a formidable task in winning the 
same confidence of the markets.

But that confidence - especially the belief that inflation will be kept under 
control - is crucial to the credibility of the US central bank.


And that credibility is what has kept US interest low, and strong growth 
continuing, despite a number of worrying economic challenges.

Mr Bernanke's plan is to institutionalise that confidence by changing the way 
the US central bank does business.

He is a leading advocate of "inflation targeting", the idea that central banks 
should set a target for inflation - in the UK it is 2% - and stick to it.

This approach was opposed by Mr Greenspan, who believed central banks needed to 
keep the markets guessing on how tough they would be on inflation.

Mr Bernanke's approach is widely adopted in Europe, by both the Bank of England 
and the European Central Bank, and supporters say it has helped to lower 
expectations of inflation among the public.

And it has been welcomed by financial markets, who like predictability.

However, it is opposed by some the US Congress, who fear it would mean the Fed 
only focused on inflation-fighting, and did not consider the effect of its 
policies on unemployment.

So Mr Bernanke may proceed slowly on this front - although he may also publish 
more details of the Fed's economic forecast, which have been kept secret so far.

Housing bubble

The new Fed chairman comes into office at a delicate moment in interest rate 

The Fed has raised interest rates 13 times in a row to 4.25%, and is widely 
expected to make another rise to 4.5% in January.

This policy is designed to cool a booming US economy, with economic growth in 
the most recent quarter running at 4.1% annually, and prevent any inflationary 
pressures building up, either from higher wages or from oil prices affecting the
wider economy.

But many analysts believe that this policy has just about run its course, and 
with US rates higher than those in many other big economies, further rises could
hurt economic growth.

However, the US is also in the midst of a huge house price boom, spurred by the 
low interest rates of a few years ago.

And so far the rate rises have had only a limited effect on that boom, because 
the Fed's short-term rates have not been reflected by similar increases in 
mortgage rates, which are fixed by long-term interest rates.

No one is sure why long-term rates have not responded - it may be low inflation 
expectations, it may be the existence of an excess of capital from abroad - but 
it does create a dilemma for the Fed.

Mr Bernanke, like Mr Greenspan, believes that it is difficult for central banks 
to intervene to prevent "asset bubbles", such as house price booms, from taking 

But that does not mean the Fed is not concerned about the "wealth effect," when 
people boost their consumer spending and debt levels too fast because they are 
thinking of how much more their house is worth - or remortgage it to the hilt.

Growing trade deficit

Mr Bernanke will also face a uncertain international economic climate.

The Fed is in charge of managing the US currency, in conjunction with the US 

So far, the boost to US interest rates has helped the US dollar to soar against 
European and Asian currencies.

But there is long-term shadow hanging over the dollar - the huge US trade 
deficit that is running at an annual rate of nearly $700bn.

As it keeps growing, fears are growing that there will be a run on the dollar, 
which would force the Fed to intervene.

Many economists argue that only a devaluation of the dollar - or revaluation of 
other currencies - can help the economy adjust in the long term.

That is one reason that the US government is pressing the Chinese so hard to 
raise the value of its currency - something that they have been resisting.

The huge trade deficit, with its flood of cheap goods, has helped to keep 
inflation in check.

So eventually, the adjustment to the trade gap could involve both a slowdown in 
consumer spending and at the same time increased pressure on prices - making 
life difficult for the Fed.

And in the longer term, the large budget deficit also puts increased pressure on
the US dollar, and reduces the US savings rate, forcing the Treasury to borrow 
more money for foreigners to fund the deficit.

It was Alan Greenspan's endorsement of the first tax cut proposed by President 
Bush that helped secure its passage in the US Congress.

Many economists now worry that making the tax cuts permanent would increase that
budget deficit too much.

Mr Bernanke has indicated that he may be more reluctant than Mr Greenspan to get
involved in the politics of the budget.

But at some point even the mild-mannered professor, whose fellow economics 
professors did not even know what political party he was a member of, may be 
forced in the political maelstrom.

In the 1980s, the "twin deficits" led to a major political crisis, both inside 
the US and abroad.

Now it could become the focus of both economic and political concerns, as the 
next US election cycle kicks in.

Story from BBC NEWS:
Published: 2006/01/02 00:56:30 GMT


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