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Bracing for a new maestro
As financial markets prepare for a new Fed chair, here's how the change was handled in the past.
October 17, 2005: 2:39 PM EDT
By Alexandra Twin, CNN/Money staff writer
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NEW YORK (CNN/Money) - The Haley's comet of government, the changing of the Fed chairman is an event both rare and monumental.

Barring a complete about-face in policy when the newest chairman takes over for the outgoing Alan Greenspan, the stock market is likely to spend early 2006 not all that differently from how it is spending fall 2005: namely, worried.

Analysts expect a sideways to weaker stock market for at least the first half of 2006 as investors contend with an economy that faces both inflation and a possible slowdown. And the longer-term effects of higher prices are expected to continue to have an impact on corporate profits and consumer spending.

Plus, the Fed may keep raising short-term interest rates at least through Greenspan's last meeting in late January -- as Fed funds futures suggest. Even if the Fed then paused its campaign with the start of a new chair, that would mean the market would spend the first half of 2006 dealing with the aftermath of a 19-month rate hiking campaign.

The Fed funds rate, an overnight bank lending rate, currently stands at 3.75 percent after 11 consecutive rate hikes.

"I think the market is going to have a good decline early next year because of all the broader issues," said Harry Clark, CEO of Clark Capital Management Group. "To an extent, it doesn't matter who replaces Greenspan, assuming it's not a shocker."

Who would the market prefer?

The likelihood of President Bush nominating an out-of-left-field replacement for Greenspan is pretty slim, analysts say. Although as the nomination of Harriet Miers to the Supreme Court indicates, Bush sometimes surprises.

"The only problem would be if Bush picked someone who is a crony or doesn't have experience," said Rajeev Dhawan, director of economic forecasting at Georgia State University, since previous Fed chairs all came from banking or economic backgrounds.

However, the stock market will likely get a candidate it's at least familiar with.

Top contenders include ex-Fed governor and current White House adviser Ben Bernanke; Harvard economist Martin Feldstein; and Glenn Hubbard, a past advisor to President Bush. The White House is also reportedly looking at some less commonly mentioned, but no more controversial choices. (For more on potential successors, click here.)

The U.S. markets would probably be fine with the frequently-mentioned candidates, as they're well-respected in the U.S. financial community, said Joel Naroff, Chief Economist at Commerce Bank and president of Naroff Economic Advisors.

The issue for the markets is confidence, Naroff said. Investors will look at the new chair and wonder "if we have a financial crisis of one form or another, do we have the confidence that this person has the experience to handle it well?"

However, Naroff thinks the new chair will come from beyond the usual list, with the focus on someone who would satisfy both the domestic and international markets, what with so much of U.S. Treasurys owned by overseas investors. A CEO of a big multi-national company might be a possibility, he said.

That would certainly soothe investors, but how the markets react to the new person will reflect many factors.

"It will depend more on the phase of the business cycle and the credibility of the institution, namely the central bank, and the person," said Georgia State's Dhawan.

The surprise factor

The market's reaction to previous new Fed chiefs has been short-term, with the more surprising the person, the bigger the market's move. (For details, see the chart.)

The transitions in the 1970's and 1980's from Arthur F. Burns to G. William Miller to Paul Volcker to Alan Greenspan contained a variety of surprises, and stocks generally showed a knee-jerk reaction.

Burns served from 1970 to early 1978 and was eligible to serve another term. However, President Carter opted not to reappoint him, instead appointing Miller.

Investors were less than thrilled with the appointment of Miller, noted Ken Kuttner, Danforth-Lewis Professor of Economics at Oberlin College. Stocks slipped and the dollar sank 2.4 percent in the first three days after he was named, Kuttner said. However, the market eventually recovered.

Miller was allowed to resign less than a year-and-a-half later and was sent to the Treasury, making the way for Paul Volcker.

Volcker's appointment in 1979 was regarded as a positive for both stocks and the dollar, as he was seen as someone who could cool inflation, the economists said.

After Volcker's resignation and Greenspan's appointment in 1987, stocks hiccuped, the dollar fell and bond yields rose, but then recovered pretty quickly, Kuttner said. Stocks reacted negatively in that "Greenspan was something of an unknown quantity at the time, while Volcker had built up very strong anti-inflation credentials over the years."

In each of those cases, the turnover was something of a surprise, Kuttner said, but by contrast, everyone knows Greenspan is leaving in January.

Another contrast is the economic environment itself. "In the 1970's we were in an environment that no Fed chair had been through in a modern economy," Naroff added, referring to soft growth and soaring inflation.

Surprise or no surprise, there are all kinds of other factors that determined whether the market gained in the first year of various chairs.

The S&P 500 added 14 percent in the 12 months after Miller took office.

"From that perspective, Miller looks like a good chairman," said Georgia State's Rajeev Dhawan. "But he was basically fired."

Stocks rose under Miller in the late 1970's in a combination of some relief rallying after the tough early to mid-1970's and because Miller extended Burns' policy of 'easy money,' which led to higher gross domestic product growth that year, said Oberlin's Kuttner.

And what about the maestro himself? In the first 12 months after Greenspan took over as Fed chair, the S&P 500 tanked 20 percent. Was it a lack of support for the new chair? Nope. On October 19, 1987, two months after Greenspan took office, the stock market crashed.

The Greenspan effect

The morning after the '87 crash, Greenspan had the Fed issue a short statement before the start of trading offering reassurance that the central bank was ready to provide liquidity to support the financial system.

One of the many factors that has distinguished Greenspan and the central bank of the last 18 years has been this kind of communication, as well as the Fed's much-discussed move toward greater "transparency."

Markets aren't typically shocked by Fed policy moves, due to the availability of the central bank's statement and minutes from each policy meeting, as well as the tendency of Fed officials to hint at what they are thinking in public speeches.

All of which makes the market even more likely to handle whatever the new Fed chair brings, assuming that this trend continues.

The question is how much of the Fed's credibility is about Greenspan personally, versus the institution over all, Kuttner added. "Hopefully his successor, whoever it is, will demonstrate that the good policy we've had over the past 18 years is as much due to the evolution of the institution as it is to Greenspan per se."  Top of page

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