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Thursday July 28, 2005 - 14:22:44 GMT

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Greenspan enters last six months

Greenspanís stabilising influence on US markets has been a crucial factor over the past few years with a high degree of market confidence in his ability to mange US interest rates and the economy. Despite some question marks over delays in monetary tightening ahead of the dotcom collapse, his presence has been very important in supporting overall market confidence and lowering US risk premiums.

In the short term, Greenspan will want to keep inflation under control and this may provide a bias for further Fed tightening. His departure next year, however, will inevitably result in a period of greater economic and market uncertainty, especially as it will take time for the new Chairman to gain authority. There will be a risk of increased volatility and investors may also require a higher risk premium on US investments in general. Delays in approving a new Chairman would also be destabilising

The overall implications for the US currency are liable to be negative, particularly if markets fear that the next Fed Chairman will look for opportunities to relax monetary policy and could find it more difficult to take an independent stance and resist administration pressure. These risks are likely to increase if the economy starts to slow, although the adoption of an official inflation target could ease these concerns.

Long period of Fed stability Ö

The 1987 Wall Street crash, the US economic recessions of 1990/91 and 2000/01, two Iraq wars, the dotcom bubble collapse in 2000 and the LTCM hedge-fund crisis in 1998. One common factor surrounding all these events and more is that the US economy and financial markets have been steered confidently through these uncertainties by Fed Chairman Greenspan.

Greenspan was initially appointed in 1987 and there was early controversy when he moved to increase US interest rates, one of the factors which was blamed for the October stock market crash that year. He was officially reappointed as Chairman in 1993 for a 12-year term.

... but there will be big changes in 2006

Greenspanís term is due to expire on January 31 next year and although Greenspanís tenure could be extended slightly if a successor has not been named or approved by then. Greenspanís term of office is, however, coming to a close as it is highly unlikely that he will be named for another term.

The issue of Greenspanís successor is likely to become a more important market focus over the next few weeks, especially with markets forced to contemplate life without Greenspan. Given his long tenure in office and mastery of economic detail together with the fact that he has played a key role over the past 17 years, his departure will cause some significant anxiety. Greenspan has held tight control of the Fed and his departure will tend to raise doubts over the course of economic policy. Regardless of who is chosen to succeed him, the transition will inevitably inject greater uncertainty into markets, especially as it will take time for a new Chairman to gain authority.

Greenspanís ability to read the US economy has enabled the Fed to avoid destabilising shocks and there will be fears that the new chairman will not be as sensitively tuned to small changes in economic trends. In this environment, there will be a greater risk of policy errors. There will also be increased risk of splits within the Fed without the dominance of Greenspan. There will be the risk that the overall market risk premium on the US economy will be higher during the first half of 2006.

Although Greenspan has, in general, ensured stability, the high levels of debt accumulated over the past five years and the difficulty in unravelling the excesses seen after the dotcom bubble may eventually be seen as an important factor in undermining Greenspanís reputation. Greenspanís successor will have to deal with the potential risks resulting from very high debt levels and a potential bubble in the housing sector, concerns over which have grown over the past quarter, especially with very strong sales. If there are major stresses in the housing sector, Greenspanís reputation would be tarnished further.

In the short term, Greenspan is likely to err on the side of a restrictive monetary policy to help bolster his legacy and ensure that inflationary pressure is not a serious problem over the next few months. This stance would tend to support he US currency on continuing yield support.

Important role for administration

In general, over the past few years, the Bush Administration has shown a preference for policies which promote strong growth. There will, therefore, be a suspicion that the administration will push for a candidate who prefers low interest rates and pro-growth policies. There are also two other fed board vacancies to fill and this will give the administration a powerful opportunity to re-shape the Fed. This combination would tend to be a negative factor for the US currency in the medium term.

There will also be a risk that the new Fed Chairman will find it more difficult to adopt an independent stance and could be deterred from further interest rate increases. There would also be the risk that Fed pressure for the administration to curb the budget deficit would be diluted.

There will also be concerns over an acrimonious series of approval hearings within Congress and this could result in a destabilising period of uncertainty even if Greenspan is left in place. Any sign of a protected dispute would tend to weaken the US currency, especially given the marketís dislike of uncertainty. Rejection of the administrationís choice would undermine confidence in US financial markets.

Inflation target could be considered

Greenspan has, however, been an important opponent of an official inflation target and the change in leadership could provide a boost for the proponents of inflation targeting within the Fed. The new Fed Governor may be more willing to adopt an inflation target, especially as it would be likely to make the task of steering monetary policy slightly easier, at least in the short term.

At present, the Fed has to balance the needs of price stability and employment, and the sole objective of an inflation target would lessen the risk of a conflict between inflation and employment considerations.


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