• By this time next year, we will likely have a new Chairman of the Federal Reserve, as Alan Greenspan’s 14-year term will have expired.
• Greenspan has established himself as one of the most powerful and respected chairman ever to lead the Fed, and his replacement will have big shoes to fill.
• Financial markets rarely react well to change, so expect higher volatility and a sell off in Treasuries, the dollar and U.S. equities when the announcement is made.
• Don’t expect a lasting negative effect as there are a number of strong candidates -- unlikely to change the independent structure of the Federal Reserve -- waiting in the wings.

For more than a quarter of the century the capital markets and the economy have had the benefit of two iconic leaders of monetary policy at the Federal Reserve.  Paul Volcker ran the Fed from August 1979 through August 1987 and in less than a decade he reestablished the Fed’s creditability and defused what had been the very real threat of U.S. hyperinflation.  In the summer of 1987, Paul Volcker gave way to Alan Greenspan, who within months displayed his extraordinary skills as a crisis manager by appropriately recognizing the need to ease monetary policy following the October 1987 stock market crash.  Greenspan continued to utilize his crisis management skills on several occasions following the S&L meltdown in the early 1990’s, the Russian debt default in the fall of 1998, and the September 11, 2001 tragedy. 

Paul Volcker changed the focus of monetary policy by targeting the growth in reserves via the monetary aggregates and reestablished the Fed’s credibility, albeit in a somewhat secretive fashion.  In contrast, Greenspan has provided more openness about the Fed and the inner workings behind the formulation of monetary policy over the last several years.   However, Greenspan’s leadership at the Fed appears to be in its final year and another change at the top of the Fed will take place that could increase short term volatility and uncertainty to the financial markets. 

When?

Although Greenspan was appointed to his fifth, four-year term as Chairman of the Board of Governors of the Federal Reserve System on June 19, 2004, his 14-year term as a Fed governor expires on January 31, 2006.  By law he cannot be reappointed to another term. However, he can continue to head the Fed until a replacement is named by the President and confirmed by the Senate. Given that the White House has been a bit behind in filling a number of vacancies there is an outside chance that this process could drag on well into next year, possibly making Greenspan the longest serving Chairman of the Federal Reserve.

What happened to the financial markets the day it was announced that Greenspan was replacing Volcker?

On that day, longer-dated Treasury yields rose 25 to 35 basis points, the trade-weighted dollar index declined 1.7 percent, and the S&P 500 Index dropped just a token 0.5 percent. However, the change in leadership at the Fed did not have a long-lasting negative impact on the financial markets as the sanctity of the Fed as an institution was more than maintained under Greenspan’s leadership. 

The changing of the guard at the Fed in 1987 came as a surprise to the financial markets as Volcker’s 14-year term as a Fed governor was not close to expiring.  Many people felt that since Volcker  had survived the ouster attempts by President Reagan’s Treasury Secretary Donald Regan in mid-1983 and had navigated the financial markets past the Latin American debt crisis, his position as Fed Chairman was secure for a third term. This was not the case.  Back in 1983, Don Regan’s desire to replace Volcker was largely thwarted by the lack of investor support for his potential replacement, the one and only Alan Greenspan.  An institutional investor survey conducted by Dick Hoey, a noted economist, in May 1983 revealed overwhelming support (76.9 percent) for the reappointment of Paul Volcker as Fed Chairman.  Alan Greenspan received a mere 5.8 percent of the vote.  By 1987, the public had become a bit more positively disposed to Greenspan, while the Administration was still uncomfortable having someone that was originally appointed by Jimmy Carter running monetary policy.  The Administration made the decision that they would reappoint Volcker only if he asked. At the same time, Volcker made a decision that, in part due to health issues in his family, he would only serve another term if asked by the Administration.  Neither asked and the net result was a Tuesday morning press conference announcing that Greenspan would replace Volcker at the helm of the Fed.

How will the financial markets react to the change in leadership at the Fed?

We will likely see a mini-repeat of prior history as a changing of the guard at the Fed will fuel some indigestion in the capital markets, with the long end of the bond market and the dollar bearing the bulk of the negative consequences.  However, as was the case with the original appointment of Greenspan, this should be a short term event as long as the independence of the Fed is maintained.   

How will Greenspan be viewed as a Fed Chairman?

Many people will view Greenspan as the best Fed chairman ever.  We will simply view him as one of the best. Over the last fifty years, William McChesney Martin, Paul Volcker, and Alan Greenspan should be viewed as perennial all stars. Martin served as Fed Chairman from 1951 until 1970 and was largely viewed as establishing the Fed’s credibility. Greenspan did a masterful job during his similar length tenure with his reign being highlighted by his crises management skills and the opening up of the secrecy of the Fed.  However, my choice for number one as Fed chairman goes to Paul Volcker.  He had the most difficult job combating and winning what Greenspan himself has termed a very real threat of hyperinflation.

Who will be the Next Fed Chairman?

The leading contender to replace Alan Greenspan as Fed Chairman appears to be Ben Bernanke, followed by Martin Feldstein. Ben Bernanke is an MIT-trained economist who taught at Princeton for many years, served as a visiting scholar at several Federal Reserve Banks, and has been a member of the Board of Governors at the Fed since 2002.  He is generally well respected by the financial community and has published on a variety of macroeconomic and monetary policy issues.  In contrast to Greenspan, Bernanke is not perceived as an expert on fiscal policy matters related to tax policy, social security, and budget deficits, which could make him a more appeasing Fed Chairman for the current Administration.  In what appears to be a testing of the water, President Bush announced in early April that he selected Bernanke to chair his Council of Economic Advisers (CEA).  Some analysts doubt Bush would tap Bernanke to serve as head of this council if he plans to make him Fed chairman within the next year.  However, the council often is made up of a revolving group of economists that serve less than two years. A brief stint at the CEA could give the Administration and Bernanke a chance to see how they work with each other.  If a positive working relationship develops, it could be a stepping stone to Bernanke’s quick return to the Fed’s Board of Governors, but this time to replace Greenspan as chairman of this group.  

If the Administration wants to replace Greenspan with an economist with top credentials and experience most similar to his, Martin Feldstein might be the choice.  Feldstein headed the CEA during the Reagan Administration and is well respected, both domestically and internationally, on a variety of fiscal and monetary policy issues.  However, Feldstein’s strong fiscal policy views could place him at odds with some of the Administration’s policy plans.  Feldstein’s association as a director of American International Group has recently been voiced by some Fedwatcher’s as a reason that he will not get the nod.  However, many years ago one of the skeletons in Greenspan’s closet was that prior to joining the Fed he had done some consulting work for Charles Keating (of the Lincoln S&L debacle fame) and praised the direct investment of S&L's as a way of diversifying and theoretically strengthening their balance sheets.

Who are the surprise potential candidates?

The financial markets do not like the idea of surprise candidates running the Fed so if someone other than Bernanke or Feldstein makes it to the true evaluation process that individual would likely be “leaked” to the financial markets as a trial balloon before the fact by the Administration.  R. Glenn Hubbard, a former chairman of the Council of Economic Advisors and the current dean of Columbia’s business school, might be such a potential candidate.  In contrast, John Taylor, who several years ago was strongly viewed as a potential replacement for Greenspan, now appears to be a less likely choice.  Taylor, a longtime Stanford University economics professor, who developed the “Taylor rule” which is often used by economists to predict changes in interest rates by the Federal Reserve, recently ended his stint as a Treasury Undersecretary for International Affairs.  Lawrence Lindsey, a former Fed Governor and economic adviser to President Bush might rekindle his lobbying efforts for the top post at the Fed.  Greenspan might suggest the elevation of current Fed Governor, and lifelong Fed staffer, Donald Kohn as his replacement.  Finally, if the President aims for someone from Texas former Federal Reserve Bank of Dallas President Robert McTeer (currently Chancellor of the Texas A&M University System) would be an excellent choice.

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