Tuesday, October 11, 2005

Morgan Stanley: No Harriet Myers-types for the Fed, please



More from Stephen Roach...
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Historically, the Fed has always been a chairman-dominated institution. Yes, policy is made by committee -- a seven-person Board of Governors, joined by a rotating group of five of the 12 District Bank presidents (that always includes the representative from New York). While each member of the Federal Open Market Committee has one vote, the Chairman’s vote has always carried the greatest weight in the deliberations of the modern-day Fed. As such, it should not be surprising that financial markets take the transition to a new Fed Chairman as a very serious event. This one person has long been emblematic of the character of the institution.

The history of recent Fed leadership transitions does not read well in the financial markets. The last one occurred in August 1987, when Alan Greenspan assumed the reins of power. A little more than two months later, the US stock market crashed. Paul Volcker became Chairman in August 1979 -- a transition that that was quickly followed by a wrenching sell-off in the bond market. And the US dollar was in serious trouble from the very start of G. William Miller’s brief term as Fed chairman, which commenced in March 1978...



... Going from the known to the unknown is invariably unsettling -- even under the best of circumstances. Unfortunately, the circumstance surrounding the last three Fed transitions were far from ideal.

Alas, that is very much the case today. Saddled with a record current account deficit, the US is more dependent than ever on the confidence of foreign investors to fund ongoing economic growth. When Greenspan hands over the reins to his successor in early 2006, the current account deficit will be at least 6.5% of GDP. That’s more than four times the average external shortfall of 1.5% that prevailed during the three most recent transition points -- 1978, 1979, and 1987. Moreover, in a post-Katrina, energy-shocked climate, there is good reason to expect additional reductions in personal and government saving in the months ahead -- actually, deeper dis-saving (deficits) on both counts. As a result, already-depressed national saving should move even lower, prompting further deterioration in America’s already massive current account deficit. In other words, America’s dependence on the “kindness of strangers” is likely to increase significantly at precisely the point of an historically-delicate transition to a new a new Fed chairman.

And that, I’m afraid, brings me to the most controversial point of all -- the selection process, itself. With the consent of the US Senate, the choice of selecting a new Fed chairman falls to the President. Generalizing on the basis of George W. Bush’s most recent senior appointments, I suspect the President will look for three key traits in a new Fed chairman -- familiarity, loyalty, and a pro-growth bias. This is not meant to be critical. It is a carefully determined observation based on the President’s record. In the case of a Fed Chairman, those criteria imply that President Bush will probably not select the next Paul Volcker -- a tough, independent policy maker who might be predisposed toward “tight money.” While this is inconsistent with the President’s statement on this matter at a recent press conference, in the end, I still believe George W. Bush will opt for a trusted team player who shares the goals and objectives of his political agenda.

This could well pose a serious problem for US financial markets. With America’s external financing critically dependent on the foreign confidence factor, any doubts over central bank independence will not go over well. That’s especially the case for a US economy beset with record imbalances, a potential inflation scare, and bubble-like conditions in asset markets. Foreign investors have been extraordinarily generous in the terms they have offered for funding America’s external deficit. In part, that generosity may reflect the “Greenspan factor” -- the confidence that investors have in Alan Greenspan’s adroit management of periodic international financial crises. With the Greenspan factor about to be taken out of the confidence equation, any fears of an “easy money” Fed could well prompt foreign investors to exact concessions in those financing terms in the form of a weaker dollar and higher real interest rates.

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