Fed chairmen and the scary mask

Eons ago, in the pre-Alan Greenspan era, Paul Volcker (Mr. Greenspan's predecessor as chairman of the Federal Reserve System) was touring the Museum of Anthropology at the University of British Columbia. He pointed to an especially fierce native American mask.

"That must have been for their central banker," Mr. Volcker joked for the benefit of the journalists tagging along.

Come Feb. 1, Ben Bernanke will be the one that journalists tag behind when - as expected - he succeeds Greenspan. Will Mr. Bernanke have to figuratively don a ferocious mask in order to tame inflation?

Probably not. But he may have his own monster to tame.

When Fed policymakers raised the short-term interest rate on federal funds to 4.25 percent last Tuesday - the 13th straight hike since June 2004 - they stated cautiously: "Core inflation has stayed relatively low in recent months and longer-term inflation expectations remain contained. Nevertheless, possible increases in resource utilization as well as elevated energy prices have the potential to add to inflation pressures."

Translation: "Core" inflation ignores higher energy or food prices. "Resource utilization" likely refers to a possibility of lower unemployment, which would let workers insist on higher wages.

Central-bank chiefs of industrial countries pride themselves on being tough on inflation. Volcker put on his central-banker scary mask to tame rampant inflation soon after taking office. On Oct. 6, 1979, the Fed announced what a Monitor article described as "a historic decision that offers the promise of eliminating inflation in three or four years." It also guaranteed a recession and "considerably more unemployment."

From July 1981 to November 1982, the United States suffered its worst recession since the Great Depression. Volcker's brief switch to a "monetarist" Fed policy, with the central bank giving prime attention to restraining growth in the nation's money supply, succeeded. It stopped double-digit inflation. The cost was high, but Volcker left an economy to Greenspan that was far healthier than it was when Volcker took the job.

Greenspan's Fed is expected to raise interest rates another 0.25 percentage points on Jan. 31, 2006. That, some Fed-watching economists suspect, may be the last rate hike for a while. (They point to the fact that an ongoing description of monetary policy as "accommodative" was removed from the latest statement of the Fed policymakers.)

Bernanke could decide, of course, to establish his credentials as an inflation-fighter by pushing his colleagues on the Federal Open Market Committee for another interest rate hike.

But economist Paul Kasriel, for one, doesn't see inflation as Bernanke's biggest challenge. "I don't see a flare-up in inflation," says the Northern Trust Company chief economist in Chicago. The growth in the inflation-adjusted money supply, considered by economists as the fuel that can inflame inflation, has been "pretty weak," he says.

But he does expect a decline in the annual real growth rate of the US economy. He sees that rate falling to about 3 percent in the current quarter, down from 4.3 percent over the summer.

Bernanke, while serving as a fellow governor of the Fed with Greenspan, voiced his concern about deflation - falling prices, not rising ones. He has done groundbreaking research on what caused the Great Depression and the Fed's role in that economic disaster.

Bernanke is aware that an inadequately generous monetary policy led to years of stagnation in Japan in the 1990s and early 2000s. The economy of the 12-nation euro-zone has been struggling for years, partly because the European Central Bank has been aiming to keep inflation at 2 percent or lower.

What really concerns Mr. Kasriel is that Bernanke faces an economic "accident waiting to happen," arising from the huge deficits in the nation's current trade balance, its federal budget, and in the books of households. "The nation is leveraged to a degree never seen in the postwar period," says Kasriel.

The nation owes foreigners $5.5 trillion more than the US owns in foreign assets. With the cost of hurricane Katrina mounting, rising interest payments on the national debt, and increased Medicare and Medicaid spending, the federal budget deficit last month ($83.66 billion) was 43 percent more than it was in November 2004.

Last quarter, household spending exceeded income at an annual rate of $572 billion - a sum bigger than the federal budget deficit. Households have been in a deficit position since the late 1990s, relying to a major extent on drawdowns from the value of their homes to keep buying SUVs, TVs, etc.

Kasriel expects consumer spending to slow now that house prices show signs of flattening or falling. He worries that the nation's banks, now holding massive amounts of mortgages and mortgage-related assets, will be forced to restrain their loans to business again, as was the case in the 1930s and the early 1990s in the US, and in Japan during the last decade.

"I see a lot of difficulties for Mr. Bernanke," Kasriel says. "Greenspan has really created an untenable environment."

If such difficulties do occur, Bernanke has expressed a desire to see more transparency in Fed policies. The nation may learn a lot about Fed countermeasures and intentions.

After an article I wrote in 1974 likened Fed secrecy to that of the CIA, then-Fed chairman Arthur Burns told me, "David, that column wasn't worthy of you!" Not long after, however, Burns trimmed Fed secrecy. Greenspan has since let in even more light.