[an error occurred while processing this directive]
BBC News
watch One-Minute World News
Last Updated: Monday, 2 January 2006, 00:56 GMT
Challenges ahead for US economy
By Steve Schifferes
BBC News economics reporter

Many people may not know the name Ben Bernanke. But at the end of January he becomes the world's most powerful central banker when he succeeds the respected head of the US Federal Reserve, Alan Greenspan.

Bernard Bernanke
Current job: Chairman, Council of Economic Advisors
Former job: Professor of Economics, Princeton
Strength: Outspoken advocate of inflation targeting
Weaknesses: Limited political experience

During Mr Greenspan's long term in office, he was considered by the financial markets as a key guardian of the health of the economy, and his often-enigmatic comments were closely watched for signs of his future intentions.

Mr Greenspan was widely applauded for keeping the US economy growing during the boom of the 1990s, and for managing the crises of the dot.com crash and the 9/11 attacks while keeping the wider economy intact.

Mr Bernanke, a Princeton economist who was only appointed chairman of the council of economic advisors in June, faces a formidable task in winning the same confidence of the markets.

But that confidence - especially the belief that inflation will be kept under control - is crucial to the credibility of the US central bank.

Alan Greenspan

And that credibility is what has kept US interest low, and strong growth continuing, despite a number of worrying economic challenges.

Mr Bernanke's plan is to institutionalise that confidence by changing the way the US central bank does business.

He is a leading advocate of "inflation targeting", the idea that central banks should set a target for inflation - in the UK it is 2% - and stick to it.

This approach was opposed by Mr Greenspan, who believed central banks needed to keep the markets guessing on how tough they would be on inflation.

Mr Bernanke's approach is widely adopted in Europe, by both the Bank of England and the European Central Bank, and supporters say it has helped to lower expectations of inflation among the public.

And it has been welcomed by financial markets, which like predictability.

Oil refinery
Higher oil prices could feed through to inflation

However, it is opposed by some the US Congress, who fear it would mean the Fed only focused on inflation-fighting, and did not consider the effect of its policies on unemployment.

So Mr Bernanke may proceed slowly on this front - although he may also publish more details of the Fed's economic forecast, which have been kept secret so far.

Housing bubble

The new Fed chairman comes into office at a delicate moment in interest rate policy.

The Fed has raised interest rates 13 times in a row to 4.25%, and is widely expected to make another rise to 4.5% in January.

San Francisco
Property prices in San Francisco - and other cities - have soared

This policy is designed to cool a booming US economy, with economic growth in the most recent quarter running at 4.1% annually, and prevent any inflationary pressures building up, either from higher wages or from oil prices affecting the wider economy.

But many analysts believe that this policy has just about run its course, and with US rates higher than those in many other big economies, further rises could hurt economic growth.

However, the US is also in the midst of a huge house price boom, spurred by the low interest rates of a few years ago.

And so far the rate rises have had only a limited effect on that boom, because the Fed's short-term rates have not been reflected by similar increases in mortgage rates, which are fixed by long-term interest rates.

No one is sure why long-term rates have not responded - it may be low inflation expectations, it may be the existence of an excess of capital from abroad - but it does create a dilemma for the Fed.

Mr Bernanke, like Mr Greenspan, believes that it is difficult for central banks to intervene to prevent "asset bubbles", such as house price booms, from taking place.

But that does not mean the Fed is not concerned about the "wealth effect," when people boost their consumer spending and debt levels too fast because they are thinking of how much more their house is worth - or remortgage it to the hilt.

Growing trade deficit

Mr Bernanke will also face a uncertain international economic climate.

The Fed is in charge of managing the US currency, in conjunction with the US Treasury.

Wal-Mart store
Low prices have been helped by cheap imports - and a growing deficit

So far, the boost to US interest rates has helped the US dollar to soar against European and Asian currencies.

But there is long-term shadow hanging over the dollar - the huge US trade deficit that is running at an annual rate of nearly $700bn.

As it keeps growing, fears are growing that there will be a run on the dollar, which would force the Fed to intervene.

Many economists argue that only a devaluation of the dollar - or revaluation of other currencies - can help the economy adjust in the long term.

That is one reason that the US government is pressing the Chinese so hard to raise the value of its currency - something that they have been resisting.

The huge trade deficit, with its flood of cheap goods, has helped to keep inflation in check.

So eventually, the adjustment to the trade gap could involve both a slowdown in consumer spending and at the same time increased pressure on prices - making life difficult for the Fed.

And in the longer term, the large budget deficit also puts increased pressure on the US dollar, and reduces the US savings rate, forcing the Treasury to borrow more money for foreigners to fund the deficit.

It was Alan Greenspan's endorsement of the first tax cut proposed by President Bush that helped secure its passage in the US Congress.

Many economists now worry that making the tax cuts permanent would increase that budget deficit too much.

Mr Bernanke has indicated that he may be more reluctant than Mr Greenspan to get involved in the politics of the budget.

But at some point even the mild-mannered professor, whose fellow economics professors did not even know what political party he was a member of, may be forced in the political maelstrom.

In the 1980s, the "twin deficits" led to a major political crisis, both inside the US and abroad.

Now it could become the focus of both economic and political concerns, as the next US election cycle kicks in.

The BBC is not responsible for the content of external internet sites

Has China's housing bubble burst?
How the world's oldest clove tree defied an empire
Why Royal Ballet principal Sergei Polunin quit


Americas Africa Europe Middle East South Asia Asia Pacific