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Street Split Over Bernanke Appointment

Stocks are pleased as the new Fed chief is less of an inflation hawk. But bonds recoil and some observers worry about politics.
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Updated from 1:23 p.m. EDT

Shortly after telling reporters his choice to succeed Alan Greenspan, President Bush repeated his faith in Harriet Miers, his controversial selection for the remaining open seat at the Supreme Court.

That may help explain why stocks rallied and bonds dipped -- even before Bush confirmed he had chosen Ben Bernanke, the chairman of the White House council of economic advisers, to be the next

Federal Reserve


Bernanke's appointment, like Miers', reflects political considerations, although perhaps not as many as would have attended the nomination of Glen Hubbard or Larry Lindsey, both former CEA chairs.

Unlike Donald Kohn, who was reportedly Greenspan's preferred candidate to succeed him, Bernanke will start with Wall Street not convinced that he is fully independent, says David Powell, currency analyst at IDEAGlobal.

"Even before being appointed to be CEA chairman, which is far from a politically neutral appointment,

Bernanke was aligned with the Bush tax cuts," Powell says. "Bush, who often mentions loyalty, has confidence in him."

Bush may have learned a lesson from the early 1990s, when Greenspan kept on hiking interest rates during the re-election bid of his father, George H.W. Bush, a move some observers say may have cost Bush senior the presidency.

Beyond politics, Bernanke's own track record as Fed governor and his close alignment with Bush's economic philosophy suggest less emphasis on inflation-fighting and a less-hawkish approach to monetary policy.

He was one of the most vocal Fed governors warning about the possibility of deflation several years ago. He is also known to be an advocate of inflation targeting, or setting a clear level for tolerable price increases, contrasting with Greenspan's more vague "risk-management" approach.

"Bernanke would show more inflation tolerance than Greenspan would," says John Lonski, senior economist at Moody's. "He's more likely to tell the story that a little bit of inflation is not necessarily bad for the economy."

That's music to the ears of the stock market, where the Fed's recent inflation-fighting rhetoric has sparked fears that the Fed may overshoot in lifting interest rates and throw the economy into recession.


Dow Jones Industrial Average

was recently up 128 points, or 1.3%, at 10,343. The blue-chip average jumped more than 60 points shortly after news reports said Bernanke was the appointee for the Fed chairmanship behind strength in economically sensitive components such as


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S&P 500

was recently up 15 points, or 1.3%, to 1195. The

Nasdaq Composite

was up 23 points, or 1.1.%, to 2105.

"When you sum it up,

Bernanke is the best appointment for the

stock market," says Ned Riley, chief investment officer at Riley Asset Management. "He is the most predictable and he is closely aligned with the president, which suggests an end to rate hikes sooner than later."

For the long end of the bond market, however, that's not good news. The hawkish rhetoric by Fed officials in recent weeks had helped support longer-term securities, which lose value over time when inflation rises. In recent action, the benchmark 10-year Treasury bond was down 15/32 in price while its yield, which moves inversely to its price, rose to 4.44%.

There is also the issue of the ballooning twin U.S. deficits, both budget and current account, which are not directly the responsibility of the Fed but do influence its decisions. The Fed chairman is also asked for an opinion on these during congressional testimonies.

Greenspan, while he had endorsed the Bush tax cuts, was often publicly wary of the structural imbalances that may stem from the deficits. Bernanke, on the other hand, has not been known to vehemently argue for deficit reduction.

"He believes the current account deficit is not the result of a lack of saving or of competitiveness in the U.S., but rather is the function of the savings glut in emerging markets," says Ashraf Laidi, currency strategist with MG Financial.

In order to finance the gap in the current account, which is the difference between imports and exports of goods, services and transfers (including financial flows), the U.S. has relied on foreign purchases of U.S. financial assets, especially Treasuries. But this leaves the economy vulnerable in case these purchases were to drop suddenly, which could send the dollar sharply lower U.S. interest rates sharply higher. Such concerns were evident in the market early this year.

The dollar, meanwhile, has been supported by the Fed's unwavering commitment to continue raising short-term rates since last year. This supports more attractive yields in short-term Treasuries and encourages foreign flows of money into the U.S.

The dollar had come under pressure in morning trade following news of powerful blasts in Baghdad. But a noticeable gain was seen after Bernanke's confirmed appointment, especially as he promised to "maintain continuity with the policies and policy strategies under the Greenspan era."

That promise may not be hard to fulfill at first for Bernanke, especially as Fed officials have signaled pretty clearly they intend to continue raising rates at least until January. The market almost fully expects a rate hike next week, another one on Dec. 13, and yet another one in January, which would take the Fed funds rate to 4.50% before Greenspan takes leave, according to Miller Tabak.

By then, the market should have a bit more clarity on the economic outlook after Hurricane Katrina and the recent spike in energy prices.

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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