The importance of being Bernanke

The world of central banking saw two important events last week. The Reserve Bank of India announced its mid-year monetary policy and the US administration announced the appointment of Ben Bernanke as the new chairman of the US central bank, the Fed.

From a global perspective, the second was clearly more important. However, the Indian policy announcement did send some important signals about central banking trends in general.

Let me quickly take up the local policy announcement first. The RBI hiked the key policy rates and spelt out clearly that it was not willing to "accommodate" inflationary pressures that might arise out of the mix of strong growth and fuel price hikes.

These moves not only fell in line with local market expectations but also matched the recent action of the US Fed and other Asian central banks.

This was yet another instance of the "globalisation" of monetary policy that one notices these days -- the era of discretionary policy where the central bank paid close attention to local conditions in deciding policy seems over.

The US Fed has emerged to be the sole arbiter of interest rates and monetary policy in the global scheme. Most other central banks find it comfortable to follow the Fed in its key decisions.

Instead of commenting on whether this is necessarily a good thing, let me give you my take on what it means to have a new boss at the US Fed. Not much, apparently! Most Fed watchers do not expect much of a difference between Bernanke and his predecessor Alan Greenspan, who retires at the end of January after an 18-year stint.

Both are known to be pragmatists rather than doctrinaire "hawks" or "doves". Bernanke, like Greenspan, believes in gradual policy moves and is likely to carry on with the sequence of measured hikes in interest rates in response to the threat of inflation.

The consensus among analysts is that at least five more hikes of a quarter percentage point each in the signal Fed Funds rate are due and that should take it up to 5 per cent by the middle of next year.

There are, however, some differences in their backgrounds and professional experience that could have some impact on policy style in the long term. Greenspan comes from a consulting background and was known as a "nuts and bolts guy" who knew the nuances of Washington D.C.'s political establishment well.

Bernanke, on the other hand, is an academic who had spent most of his professional life teaching macroeconomics in the pristine environs of Princeton University. His experience of the "real world" includes a stint at the Fed and his current position on the council of economic advisers to the President.

I suspect his academic background makes Bernanke more of a "bigger picture" policymaker than Greenspan. The bits of this big picture of the US economy that he is unlikely to miss are the deep imbalances in the current account, the budget deficit, and household finances.

In his speeches and writing he has made it abundantly clear that he is uncomfortable with the fact that global savings are supporting residential investment and a consumption binge in the US, rather being channelled into productive investments in developing economies.

The implication is that the rhetoric coming from the Fed is likely to dwell a little more on these "structural" imbalances than the average Greenspan testimony. This could spook the foreign exchange markets a little and the dollar's recent bull run could reverse.

Bernanke is also likely to be a little more vocal about the large undervaluation in Asian currencies that really lie at the heart of these imbalances.

Thus, the issue of a further round of revaluation of the yuan (with its implications for currencies across the Asian region) could resurface. In short, I expect the dollar bears to return at least in the first phase of the new Fed chairman's tenure.

Bernanke is also a great believer in "inflation targeting", the model in which the central bank announces an explicit inflation target and tweaks monetary policy to ensure that this is met. This introduces a greater degree of transparency into monetary policy and makes inflation management easier.

New Zealand, for instance, has followed this model with a remarkable degree of success. This is, de facto, what the Fed does at the moment but stops short of announcing a specific inflation target.

However, it's unlikely that Bernanke will get his colleague's support on this at least immediately and the Fed is likely to continue with its current model.

The new Fed chairman is also unlikely to be a rate-hike happy "bubble popper" when it comes to his stance on asset markets. In a speech before the New York chapter of the National Association of Business Economists in 2002, he candidly admitted: "First, the Fed cannot reliably identify bubbles in asset prices. Second, even if it could identify bubbles monetary policy is too blunt a tool for effective use against them."

Thus, Bernanke's tack would be "use the role of the Fed as the guardian of financial institutions to rectify the market imperfections that breed these bubbles rather than lean against them through monetary contraction". Were an asset bubble to burst, Bernanke would then use the monetary tools at his disposal to protect the financial system and restore credibility

Bernanke is also known to like Hawaiian shirts and has apparently made a strong case to jettison the practice of wearing business suits at the central bank offices. The odds are clearly stacked against him on pushing this policy initiative through.