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Who heads the Fed matters for our economy too

Date Released: Wed, 21 August 2013 08:59 +0200

The chairmanship of the US Federal Reserve has been described as the most powerful financial position in the world, so it is not surprising that whenever the position is to be filled, considerable attention is paid to possible candidates and their likely approaches to monetary policy in the world’s largest economy.

The second term of office of Fed chairman Ben Bernanke ends in January. He could be reappointed, but President Barack Obama recently hinted that Bernanke wishes to retire. This has prompted speculation about who succeeds him and the effect this could have on US monetary policy. Speculation is even more intense than usual because the outlook for the US economy and its management is uncertain.

Bernanke is a renowned academic and the foremost authority on the Great Depression. His supporters suggest that he quickly recognised that the 2008 financial crisis could easily lead to a repeat of the economic catastrophe of 1929.

The Fed is believed to have compounded the Great Depression by failing to rescue US banks from collapse, so Bernanke made sure this mistake was not repeated. He cut interest rates to almost zero and recapitalised troubled commercial banks by buying so-called toxic assets from them. This enabled them to return to their role as providers of credit to US consumers and businesses. He saw this as essential for getting the economy growing again, but his detractors accuse him of bailing out the greedy bankers who got us into the mess in the first place.

Refinancing the banks was not enough. It was necessary also for businesses and households to want to borrow for credit-funded spending to resume. Because US mortgage interest rates are closely tied to government bond rates, Bernanke also made big purchases of government bonds to push down their interest rates. Lower long-term interest rates encouraged households to restructure their mortgages, reducing some of the costs of high personal debt. Eventually this encouraged households to start borrowing again.

According to the International Monetary Fund, the US economy will grow 1.7% this year and 2.7% next year. This is attributed by Bernanke’s supporters to his conduct of monetary policy. But Bernanke has suggested that the time is not far off when quantitative easing ends and US interest rates start to rise. There is concern that when this happens, the US’s economic recovery may falter, hence the focus on whose hand will be on the Fed’s tiller when this happens.

Media speculation is that there are two frontrunners. The first is Bernanke’s deputy, Janet Yellen. If appointed, it is expected that she will not change the policies she helped Bernanke craft. Yellen has extensive experience in public office, including as economic adviser to former president Bill Clinton. She has a reputation as a monetary policy "dove" — she has a preference for lower interest rates to support economic growth. Under her leadership, monetary conditions would probably tighten only gradually, with a keen eye on their effect on the economic recovery.

The other frontrunner is Larry Summers, who, like Bernanke and Yellen, is a renowned economist. A former chief economist of the World Bank, Summers was Treasury secretary under Clinton and was Obama’s economic adviser at the start of the financial crisis. To his supporters, Summers knows his way through the political minefields that befuddle US economic policy-making.

He is experienced at handling economic crises, having been at the US Treasury during the Asian and Mexican crises, as well as the collapse of Long Term Capital Management. Summers, his supporters suggest, will be a sound leader if another crisis emerges. His detractors suggest his deregulation of banks and refusal to regulate derivatives markets while Treasury secretary set the scene for the financial crisis. They also argue that he attracts controversy. He was, for example, forced to resign as president of Harvard University after remarks deemed to be derogatory towards women.

The financial media will focus on any hints about whom Obama will nominate as Bernanke’s successor. Obama has described this decision as "one of the most important economic decisions I’ll make in the remainder of my presidency".

Based on the old adage that "when the US sneezes, the rest of the world catches cold", we should also watch developments with interest. Neither of the frontrunners is likely to raise interest rates rapidly or lose focus on sustaining the recovery.

This is good news for us, as even the hint of higher US interest rates can negatively affect foreign capital inflows into South Africa and the rand. The slower the rise in interest rates, the less painful will be the adjustments we must make. It is also in our interest that the rich countries of the world, led by the US, should recover from the recession of the past five years. They are our largest trading partners; if they grow, our exports will grow and our economy will benefit.

BY GAVIN KEETON

Picture credit: www.thegurdian.com

Keeton is with the economics department at Rhodes University.

Article Source: Business Day

 

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