Goodbye, Gentle Ben

Testifying before Congress, the new Fed chairman needs to establish his anti-inflation bona fides.
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Ben Bernanke, the new chairman of the

Federal Reserve

, was once nicknamed "Helicopter Ben" for suggesting during the deflation scare of 2003 that a central bank could always dump money from the sky to jump-start the economy.

The suggestion earned Bernanke a reputation in financial markets for being a dove on inflation, meaning that he might be less inclined to raise interest rates if doing so risked stifling economic growth.

However undeserved the reputation might be, some Fed watchers believe that Bernanke's main task during his first testimony to Congress Wednesday and Thursday will be to remove any suspicion about his inflation-fighting credentials.

"He'll want to do whatever is necessary to counter this exaggerated image of 'Helicopter Ben'," says John Lonski, chief economist at Moody's Investors Service. "That means he doesn't want to show weakness in regards to enemy No. 1, and that's price inflation."

Bernanke had already begun to

deliver that message during his confirmation hearing back in November, when he spoke of "miscommunication" between him and the markets during the 2003 deflation scare.

But replacing Alan Greenspan at the helm of the Fed means more than that. Bernanke is inheriting a legacy of stable growth and low inflation. This legacy is, rightly or not, largely associated with and attributed to Greenspan's prowess.

Now that he's officially the man in charge at the Fed, Bernanke will "want to be seen as the champion of low inflation" to "help convince financial markets that he'll ensure continuation with Greenspan," Lonski says.

Should he choose to accept it, Bernanke's mission to convey he's an inflation fighter has been made easier: After a fourth-quarter setback, economic growth and inflation pressures are rebounding in the first quarter. Employment and wage pressures picked up in January, and consumption also seems to be rebounding, as reflected by January's blockbuster retail sales report.

That big rebound in January retail sales sparked a rally for stocks Tuesday as bonds fell ahead of Bernanke's testimony.

The

Dow Jones Industrial Average

soared 136 points, or 1.25%, to 11,028, closing above 11,000 for the first time in over a month. The

S&P 500 index

rose 12.67 points, or 1.0%, to 1275. The

Nasdaq Composite

gained 22 points, or 1.0%, to 2262. The benchmark 10-year note ended the day down 8/32 of a point to yield 4.59%, while the 30-year bond was down 17/32 to yield 4.59%.

The report seemed to reconcile the stock market with the idea that the Fed may have to raise rates more than previously thought due to underlying economic strength.

The market now prices in a 98% chance that the Fed will lift its key rate to 4.75% at its March 28 meeting and 100% chance that this rate will be reached by May 10, according to Miller Tabak.

The market also now sees a 70% chance that 5% will be reached by the May meeting and 94% by the June meeting. Odds that the Fed would hike to 5% by the end of June were only at 24% just two weeks ago. Few believe, for now, that the Fed may tighten beyond 5%, turning the monetary policy bias from "neutral" to "restrictive" for economic growth.

Much of the hawkish tone Bernanke will likely adopt therefore seems to be already priced in by the market. This will likely make it interesting to hear what his views are on the slowing housing market, which is casting a large shadow on the future of the economy.

Alarming Froth

In his final year at the Fed, Greenspan began sounding alarm bells about the housing market, which has fueled consumption via ever-rising home equities. Greenspan, who largely created this environment by cutting rates to 1% in 2003 and keeping them there for a year, had began referring to "froth" in the real estate market.

The danger looming out there is that a sharp correction in home prices would take away the cash cow used lavishly by indebted consumers over the past few years, sending consumption into a tailspin and the economy into recession.

The housing market has begun to slow noticeably since last summer, and according to homebuilders such as

Toll Brothers

(TOL) - Get Report

and

KB Home

(KBH) - Get Report

, the real estate outlook isn't getting any brighter.

Will Bernanke risk lifting interest rates much further, and perhaps precipitate a collapse in home prices?

According to J.P. Morgan economist Robert Mellman, the debate will likely be playing out at the Fed in the coming months. But Bernanke might shed some light on the issue over the next two days. "The testimony and response to questioning should indicate how seriously Bernanke views the inflation risks and how he views the durability of the expansion in light of what looks like a significant downturn in home sales," Mellman wrote.

Another big consideration will be how Bernanke deals with likely political pressures from Congress on both sides of the aisle. Because Republicans are facing midterm elections and are also looking ahead to the 2008 presidential elections, they are in somewhat of a bind, according to Lonski.

"They'll want Bernanke to emphasize that the economy is fine," Lonski says. "But on the other hand, they don't want to risk the Fed going too far

with tightening and having an economic slowdown in 2007," just ahead of the 2008 elections.

Bernanke will also be tested on the trade deficit with China, the ballooning current account and budget deficits, and the perceived vulnerability of the dollar and Treasury bonds.

Given that rising short-term rates have continued to attract flows into government bonds and have continued to support the dollar, Bernanke should have an easier time there. He might also repeat his November assertion that a "savings glut" from the rest of the world continues to finance the deficits.

Of course, part of the Fed chairman's job is to be reassuring. Bernanke, who has promised to be more straightforward then Greenspan, may therefore see the benefits of being vague, especially given the growing risks from a slowing housing market and the apparent need to continue raising rates.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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