Bernanke faces the ultimate test

Whatever decision Ben Bernanake takes over interest rates over the next couple of weeks and its consequences, may end up ultimately being the final verdict on his regime as Fed Chairman. For far too long, the Fed had put inflation fighting on the back-burner and has been fighting to stave off a recession. But now, inflation is becoming too real and immediate to ignore any longer, while growth is hanging precariously on the back of a temporary fiscal stimulus and the cheap interest rates.

The European Central Bank (ECB), faced with rising inflaiton, has already announced its intent to raise rates hikes and many others have already done so. According to the IMF's International Financial Statistics, global consumer price inflation is now running at an annual pace of nearly 5½ percent, compared with less than 4 percent in recent years. The acceleration in global commodity and energy prices shows no signs of easing off.

If the rates are hiked now and a process is initiated that will somehow help US avoid both inflation and recession, or a stagflation, then Greenspan will be forgotten and Bernanke will emerge out of the shadow of his predecessor and as a hero. If on the other hand, the hike in rates end up choking any remaining signs of growth, then Bernanke will be vilified and the Fed's reputation in the markets will take a hit.

The other remote possibility of keeping rates unchanged, may not be an option, especially given the rising oil prices and falling dollar. In the circumstances, the best that Bernanke can pray for, would be for a soft landing - one that would squeeze out the sub-prime and related financial market distortions and credit excesses, without stfling growth.

The cheap money policy (negative real interest rates) has contributed to many distortions in the global economy too. The cheap money policy, coupled with recessionary fears, have placed continuous downward pressure on the US Dollar, forcing it down to historic lows. With the major part of international trade in commodities, and especially oil, being priced in dollars, a depreciating dollar has had the effect of magnifying the rapidly rising commodity prices. Further, the cheap rates and the declining dollar was driving institutional investors into the emerging economy equity and debt markets, increasing their foreign exchange surpluses and their domestic money supply, thereby adding to the high commodity price driven inflationary pressures. In a way, the Federal Reserve was exporting inflation into the world economy!

As Tim Duy argues (from Mark Thoma), any hike in rates now could also have adverse consequences, especially with the housing mortgage crisis still on the balance. He writes, "Furthermore, higher rates threaten to intensify and lengthen the housing downturn; a 30-year conventional mortgage is already at 6.25%. Note also the Fed would be raising rates into what many believe will be the second wave of mortgage problems, the Alt-A and option adjustable mortgages that reset beginning in 2009. If the Fed starts raising rates meaningfully at this point, anticipate the yield curve to invert early next year, signaling a recession in 2010."

It will be interesting to see how the markets react to any US rate hike. The trade-off would be whether the markets perceive the rate hikes would contain inflation without choking growth, or not.