Wall St. and Business Wednesdays: Bumpy road seen for next Fed chief

U.S. president George W. Bush is likely to pick from five "qualified" successors to fill Federal Reserve chairman Alan Greenspan's shoes, but the markets will probably still see a period of volatility until the new candidate is fully battle tested, Goldman Sachs said Tuesday.

In its latest economic outlook, the brokerage — which paints a picture of a slowing economy and a "tough economic environment" for the second term president — said Mr. Greenspan's replacement must been named by Mr. Bush by January, 2006.

Mr. Greenspan is now in his fifth term as the head of the U.S. central bank and can't be reappointed by law, although he can continue to serve until the new Fed chief is confirmed.

"Financial markets will undoubtedly become more volatile until the new chairperson has been fully battle-tested and has earned credibility with financial market participants," Goldman Sachs said.

According to the report, the five most likely candidates for Mr. Greenspan's job are:

Martin Feldstein, president of the National Bureau of Economic Research and former Council of Economic Advisers under president Ronald Reagan;
R. Glenn Hubbard, dean of the Columbia School of Business and CEA head under President Bush;
Roger Ferguson, current vice chairman of the Federal Reserve;
Ben Bernanke, a current Fed governor;
John Taylor, Undersecretary of Treasury for International Affairs.
"All these candidates are qualified for the position," Goldman said.

"The real issue would be their ability to match chairman Greenspan's deft touch in the conduct of monetary policy."

Mr. Greenspan first took office in 1987 and has since come to be regarded as the world's most influential central banker, with decisions by the Fed sending ripples through financial markets worldwide.

Goldman also noted, however, that when Mr. Greenspan took over from the previous Fed chairman Paul Volcker, the general market feeling was that "Greenspan is no Volcker."

Of the last three Fed chairmen with long terms — Arthur Burns as well as Mr. Volcker and Mr. Greenspan — higher market volatility tended to be seen in the first years in office.

For example, Goldman said, bond market volatility was near its highest during both Mr. Burns' and Mr. Volcker's first year in office.

"For Greenspan, during the first year of his term, stock market volatility was highest and the volatility of the trade-weighted dollar was the third highest of his 17 years in office."

More broadly, Goldman said it foresees a tough road ahead, with the U.S. economy becoming increasingly out of balance, household savings remaining too low, and the current account deficit — the broadest measure of its dealings with the rest of the world — remaining too high.

"Resolving these imbalances smoothly is likely to prove difficult, because the factors that drive household saving behaviour are very different from those that determine the trajectory of the trade balance," Goldman said.

As well, the country's overall economic performance will also likely be hurt by a sharp decline in productivity growth, with the possibility that factors like higher energy prices and increase security costs tempering gains over on a prolonged basis.

The decline in productivity growth — which implies an increase in unit labour costs — will also hit corporate profits, Goldman added, noting that higher interest rates and increased tax payments will probably also take a toll. Unit labour costs are expected to climb by more than 2 per cent by the end of next year.

In terms of interest rates — the Fed's next decision is due Wednesday afternoon — the brokerage sees borrowing costs increasing by a quarter percentage point at each of the Fed's two remaining meetings this year.

That would put the Fed's key target for the federal funds rate at 2.25 per cent by the end of 2004. By the end of 2005, the rate is expected to climb to 3.50 per cent.

"We have never been terribly sympathetic with market expectations that the FOMC [Federal Open Market Committee] would pause in December for two reasons," Goldman said.

"First, slower growth would probably not deter the committee from continuing to normalize its policy stance unless slowing threatened job growth."

And second, Goldman noted, the economic slowing foreseen in its forecast doesn't materialize until late 2005.

"In 2005, the pace of tightening is apt to slow as the funds rate gets close to what Fed officials perceive as an equilibrium level," the report said.

"However, if our inflation outlook is right, this will probably stand in the way of an outright cessation."

According to Goldman's forecast, the annual rate of core inflation is seen moving up to 2.5 per cent by the end of 2005.

This article appears in The Globe and Mail.

Terry Weber

Wednesday, November 10, 2004