2 New Captains of the Economy Face Volatile Global Markets(NYTimes,6/1/06)

June 1, 2006
2 New Captains of the Economy Face Volatile Global Markets
By EDMUND L. ANDREWS
WASHINGTON, May 31 — One reached the pinnacle of wealth and prestige as a dealmaker on Wall Street. The other was an academic superstar, brilliant but somewhat shy and more at ease in Bermuda shorts than suits.
But now they find themselves side by side in confronting a stiff new test: helping to guide the economy from a period of fast growth and cheap money through one of higher interest rates, jittery markets and a falling dollar.
Henry M. Paulson Jr., the chief executive of Goldman Sachs and President Bush's choice to become his new Treasury secretary, is expected to arrive at his post at a time when global financial markets are suddenly more volatile and investors are more risk-averse than they have been in years.
Ben S. Bernanke, the former Princeton economics professor who became chairman of the Federal Reserve on Feb. 1, has already endured a baptism of fire as the Fed has struggled over when to stop raising interest rates.
Just a few weeks ago, bond prices dropped and critics complained that Mr. Bernanke lacked "manhood" or at least "Street cred" as an inflation fighter. In more recent days, investors have been rattled by the opposite fear: Mr. Bernanke might be too tough and push interest rates higher than they had thought, potentially slowing or reversing the liquidity-driven investment boom of recent years.
Mr. Paulson provoked speculation about the dollar even before he left Mr. Bush's side at the announcement of his nomination on Tuesday morning.
Mr. Paulson called for "steps to maintain our competitive edge in the world," a bland remark that some investors nonetheless interpreted as code for using a weaker dollar to make American exports cheaper in other countries.
"These two captains are forced to navigate in some very choppy waters," said Richard Yamarone, chief economist at Argus Research. "The message that the Fed is sending is that they don't have a clear grasp on the goings-on of the economy, and the same could be said of the Bush administration."
At first glance, the pairing of Mr. Bernanke and Mr. Paulson looks like an attempt to recreate the celebrated collaboration between Alan Greenspan and Robert E. Rubin in the 1990's, when the economy and the stock market soared and the federal budget swung from deficits to surpluses.
Mr. Greenspan, who ran the Fed, was not an academic but shared Mr. Bernanke's penchant for poring over economic data and challenging conventional wisdom.
Mr. Rubin, Treasury secretary under President Bill Clinton, had, like Mr. Paulson, been a chairman of Goldman Sachs. He teamed up with Mr. Greenspan to champion tough restraints on government spending, employed his credibility on Wall Street to assure financial markets that Mr. Clinton was serious about dealing with the budget deficit and played an influential role in shaping foreign policy.
Mr. Paulson, whose nomination has been praised by Democrats as well as Republicans, is almost certain to win easy Senate approval and become a central player on Mr. Bush's team.
But analysts say both he and Mr. Bernanke need to establish their credibility in financial markets at a time when the economy is in a major transition.
For the first time in nearly two decades, inflation is on an upward rather than downward trend. Energy prices remain near historic highs, even though oil prices dropped on Wednesday as immediate fears of a confrontation with Iran eased. Long-term interest rates — the fuel that powers the housing market when they are low — are on the rise.
Meanwhile, the economy faces structural budget deficits that will not disappear without major changes in taxes and spending, and the Fed could find itself in a clash with the Bush administration if budget deficits remain high.
Perhaps most important, however, investors around the world have become more anxious about the United States' huge trade deficits and its ballooning foreign debt. That is pushing down the value of the dollar, a trend that would help reduce trade imbalances but has also elevated worries about a more painful crash for the American currency.
Much of the uncertainty stems from a shift at the Federal Reserve and other central banks. After propping up economic growth by keeping interest rates far below normal levels, the central banks are removing the cushion of cheap money.
"The marketplace over all is being forced to reabsorb risk that formerly had been underwritten by the big three central banks — the Fed, the Bank of Japan and the People's Bank of China," said Paul McCulley, managing director of Pimco Advisers, the giant bond management firm. "When you've got all three taking away the punch bowl, the partyers at the party are not going to be happy."
Mr. Bernanke arrived at the Fed when monetary policy was already at a tipping point. Having raised short-term interest rates under Mr. Greenspan's guidance for nearly two years by the time Mr. Bernanke took over, Fed officials knew they were nearing the point where they could stop. But because there is such a long lag time between changes in monetary policy and their impact, inflationary pressures were on the rise and economic growth was still torrid.
In late April, Mr. Bernanke confounded markets even as he struggled to explain that the Fed needed to keep its options open by basing decisions on incoming economic data rather than maintaining monetary policy on automatic pilot.
Testifying before the Joint Economic Committee of Congress on April 27, Mr. Bernanke set off a rally by announcing that the Fed might pause in its rate increases to assess the impact of its previous increases.
What startled bond investors was Mr. Bernanke's added twist: that the Fed might pause even if "the risks to its objectives are not entirely balanced" meaning that it might take its foot off the monetary brakes, at least temporarily, even if there were signs of slightly higher inflation risks.
Bond investors, suspecting that Mr. Bernanke might be soft on inflation at a time when energy prices were shooting up, began demanding higher yields on long-term Treasury bonds.
Pundits began accusing Mr. Bernanke of vacillating.
"In jest, I've been saying that Mr. Bernanke needs to regain his monetary manhood," Larry Kudlow, an economist and talk show host, recently told viewers on CNBC. "He was people-pleasing Wall Street. Now he has got to go back on message."
Barry Ritholtz, an economic consultant and operator of an economic blog, the Big Picture, went further and called Mr. Bernanke the "Neville Chamberlain of inflation fighters."
"I got the sense that Mr. Bernanke was appeasing the stock market," Mr. Ritholtz said in an interview. "It's not that he has to go out and prove his manhood and his street-fighting cred. It's just that he has to navigate at a particularly perilous moment in the economy, and he has to navigate absolutely flawlessly."
Two days after raising the prospect of a pause, Mr. Bernanke compounded the confusion by venting his frustration about being "misunderstood" during an off-camera conversation with Maria Bartiromo, a correspondent for CNBC.
Word of the comments set off another round of feverish trading on April 29. Last week, Mr. Bernanke told lawmakers at the Senate Banking committee that his remarks to Ms. Bartiromo had been a "lapse in judgment" and that in the future, he would communicate only through formal channels.
Despite the bumpy path, Mr. Bernanke's first few months have been far smoother than Mr. Greenspan's arrival in August 1987. Bond investors, convinced that Mr. Greenspan could not match the inflation-fighting prowess of his predecessor, Paul A. Volcker, quickly pushed up interest rates on long-term Treasury Bonds.
Yields on 10-year Treasury bonds shot up from 8.8 percent to more than 10 percent during Mr. Greenspan's first two months as Fed chairman. The stock market, plagued by a host of uncertainties, fell 22.6 percent on October 19, 1987.
By contrast, rates on 10-year Treasury bonds have climbed modestly since Mr. Bernanke took office, from about 4.5 percent to about 5 percent today. One crucial indicator of inflation expectations, the difference in price between regular Treasury bonds and special inflation-protected Treasury securities, are not much higher today than when Mr. Bernanke took over in February.
Edward McKelvey, an economist at Goldman Sachs, said Mr. Bernanke's message had in fact been clear even if that left investors unsure about the Fed's next move.
"He is sending a fairly consistent message that says we're going to evaluate the data insofar as they affect the outlook," Mr. McKelvey said. "This is child's play compared to what Greenspan had in the first two or three months of his term."
Mr. Paulson may face his own trial by fire. As Treasury secretary, Mr. Paulson would have authority over the government's policy on exchange rates and the value of the dollar.
Mr. Paulson is likely to continue the policy of his predecessor, John W. Snow, in supporting a "strong dollar" but insisting that its value be determined by market forces. In practice, the administration has been content to let the dollar drift down in value for the last two years, a trend that makes American exports cheaper and imports more expensive.
Mr. Snow did not have to grapple with any major currency disruptions, but Mr. Paulson may not be so lucky.
"There are fewer certainties," said Lou Crandall, chief economist at Wrightson ICAP. "He is walking into an environment where the dollar is widely perceived to be at risk."