Bankers See Volatile Markets as Bernanke Joins Fed
    By Stella Dawson
    Reuters

    Wednesday 25 January 2006

    Davos, Switzerland - Ben Bernanke is poised to take over at the US Federal Reserve next week just as financial markets are heading into a very volatile period for which he is untested, senior bankers said on Wednesday.

    Dealers and investors worry that Bernanke, known as a sophisticated academic and inflation targeter, is more focused on fighting consumer inflation than current dangers of markets awash with cheap cash and a sharp US dollar drop, they said.

    "He is one of the world's greatest inflation targeters with no inflation to target," Stephen Roach, chief economist at the investment banking firm Morgan Stanley USA, said at the start of the World Economic Forum meeting in Davos on Wednesday.

    Markets showed their vulnerability last week.

    Japan's stock market suffered more than 6 percent of losses in two days when a high profile Internet company was raided and US stocks posted their steepest drop since 2003 on weak corporate earnings and uncertainty over the US outlook.

    The US dollar has shed more than 3 percent of its value this year.

    Roach said the market volatility could continue when Bernanke succeeds Fed Chairman Alan Greenspan in six days.

    "The risk is that he will be blind-sided, as his predecessors were, very early in his tenure by something he is not all that well prepared for and by something that the markets do not have confidence in him for," Roach said.

    Zhu Min, executive assistant president of Bank of China, one of China's top four banks, said markets are extremely sensitive to Bernanke's succession. "You have a very, very vulnerable financial economy. I expect to see volatile markets," he said.

    Greenspan steps down after 18-1/2 years leading the US Fed on January 31 and the same day, the US Senate is expected to confirm Bernanke to succeed him.

    Bernanke served from 2002 to 2005 as a Fed policymaker and before that he headed the economics department at Princeton University. He argued vigorously for the central bank to adopt an explicit inflation target. Since last June he has been chief White House economic adviser.

    Liquidity, Not Inflation

    Zhu said his background left markets uncertain about how Bernanke would respond to the challenges they face.

    Masses of cheap credit left in markets despite 19 months of Fed rate tightening - which now has been joined by other major central banks - presents a huge vulnerability, he said.

    Excess liquidity is the key issue confronting financial markets today, not consumer inflation, he and Roach said.

    The concern is that, if the Fed tightening cycle is nearing its peak, what happens if a financial shock occurs and markets do not need the usual Fed response of pumping in more money, given this excess liquidity, Zhu said.

    "People have no idea where there is a shock absorber. That is why you will have market volatility," Zhu said.

    A hallmark of Greenspan's era was to slash interest rates to soften the blow of financial market crises. Mostly recently the Fed cut rates to 1 percent after the 2000-2002 high technology stock crash. Since June 2004, it has tightened rates to 4.25 percent and is signaling that hikes are nearing an end.

    Regardless of whether markets have shown confidence in a Bernanke-led Fed so far, he will face tough tests, Zhu said.

    Roach agreed central bankers who focus narrowly on consumer price inflation are fighting old wars, when in fact deflationary pressures are rolling throughout the world from cost and wage arbitrage between developed and emerging economies.

    But Jacob Frenkel, a former Israeli central banker who is vice chairman of US insurer American International Group, said markets have given a vote of confidence in Bernanke already by showing no volatility over his nomination.

    "I am confident about the transition from Alan Greenspan," Frenkel said.

    This provoked a sharp rebuttal from Roach, who said a focus on targeting consumer inflation was too old. "Don't you guys need to get up to date and get some new weapons?"

    An early test of Bernanke's mettle could be a sharp fall in the US dollar, something long predicted by Roach due to the US current account deficit at roughly 7 percent of US GDP.

    "There is general sense he is going to be complacent on the dollar. I think that will be a big issue for him and as an inflation targeter," Roach said.