Uncertainty over Bernanke may keep bond yields high.

The Senate hearing awaits • But critics lurk. (Full story) Bernanke's Fed future • How high will the fed funds rate go? • Pimco's Gross sees a rate hike pause. • Recession ahead? More on the man • Bernanke's path to the Fed. • Why the Fed chief matters on Main Street. • Check out the future Fed head's holdings.

NEW YORK (CNN/Money) - Right after President Bush nominated Ben Bernanke to be chairman of the Federal Reserve, stock investors partied while bond investors grew more nervous about inflation.

Why?

There are a host of complex reasons but they mostly boil down to this: a lot of people on Wall Street are nervous about Bernanke's credibility as an inflation-fighter, something that hasn't been lacking at the Fed since Paul Volcker preceded Alan Greenspan at the helm of the nation's central bank.

"He's a fine nominee for the position, but the market is uncertain about how he'll play the Fed policy game," said Steve Bohlin, a portfolio manager at Thornburg Investment Management.

"And the real fear is that he won't be aggressive on price stability," he added.

After Bernanke was nominated Monday, stocks rallied, with the Dow industrials posting its biggest one-day gains since late April. (Full story). But then stocks fell for three sessions until they finally rebounded Friday on an upbeat GDP report. (Full story)

Meanwhile, the bond market started a three-day sell-off that pushed the yield on the 10-year Treasury as high as 4.61 percent on Wednesday, the highest in seven months. Bond prices and yields move in opposite directions. (Full story)

Bond investors are hyper-sensitive to worries about inflation since it erodes the value of their fixed-income investments.

In order for bond yields -- which directly influence the real estate, banking and financial services sectors -- to stay stable, Bernanke must prove himself a Greenspan-style inflation fighter, bond market and economic experts said.

That entails a willingness to preserve the value of the dollar at nearly all costs, and an ability to keep markets calm if the fight takes the economy into a recession, which happened under both Greenspan and his predecessor, the cigar-smoking, 6-foot, 7-inch Volcker.

On the day of his nomination, Bernanke tried to reassure investors that he would keep up the fight against inflation -- and be as steady a hand as the current chairman. "My first priority will be to maintain continuity with the policies and policy strategies established during the Greenspan years," he said. (Full story)

But whether that pans out remains to be seen. Greenspan was legendary for using his own instincts, as well as a dizzying arsenal of economic numbers, to help steer Fed policy.

Bernanke, by contrast, while acknowledged as a smart if not brilliant academic economist, has spent most of the past 20 years at Princeton and has little public policy experience. And his big idea that's caught the attention of economists and investors on Wall Street is proving controversial: setting explicit inflation targets as a way to promote price stability and clearer Fed policy.

"The past two Fed chairmen have been preemptive and hawkish, and in their drive to keep inflation under wraps, they steered the economy to price stability," said John Herrmann, director of economic commentary at Cantor Fitzgerald, one of the world's top Treasury bond brokers.

But now, he added, with the economy on firm footing and inflation under control, at least for now, "Bernanke could be more dovish and even pause the rate hike campaign. Alan Greenspan might look at the same factors and act preemptively to strike at inflation, if he sensed inflationary pressures."

On the other hand, Thornburg's Bohlin says an inflation target could be overly hawkish, and push the economy into a recession.

"If central bankers are committed to hitting a target, they might have to tighten up the money supply at a time when rate hikes could cause a dramatic economic slowdown," he said.

But Bill Gross, managing director at Pimco, the nation's biggest bond fund, said Thursday that he backs inflation targeting. (Full story)

"Inflation-targeting central banks in other parts of the world, such as the United Kingdom and implicitly the European Central Bank, have economies with lower inflation and lower long-term yields than here in the United States," he wrote in his latest market commentary.

Both Herrmann and Gross believe that Bernanke is inheriting a benign inflation picture, giving him room to pause should high gasoline prices, soaring home heating bills or a slowdown in the housing market threaten the economy.

But Bohlin said we're dealing with a much murkier picture than what some people assume, "and good, clean data is essential in making central bank policy."

While Bernanke will inherit a "core" inflation rate of about 2 percent, the upper limit of what Fed officials are reportedly comfortable with, the consumer price index overall including food and energy costs has jumped to 4.7 percent, the highest level since 1991.

The disparity has sparked a debate over whether higher energy costs will start seeping into other parts of the economy, pushing wages and other prices higher. If that's the case, the Fed may have to raise rates much more aggressively.

The central bank has already raised rates 11 times starting last June, and another rate hike is widely expected when the central bank's policy-makers meet next week.

Bernanke has said energy costs will not put upward pressure on other prices, making some bond traders nervous that inflation could get out of hand and have to be reigned in later with drastic rate hikes that could slow the economy or even spark a recession.

Old hands on Wall Street remember that it was Greenspan's willingness to boost rates no matter what that helped build the foundation for the boom years of the 1990s, the longest peacetime economic expansion in the nation's history, by turning the Fed into a credible inflation fighter.

Greenspan decided it was more important to tame creeping inflation that worry about economic fallout from the Black Monday stock market crash of 1987, and raised rates less than a year after the crash.

"But Bernanke, as an expert on the Great Depression, will be more sensitive to an economic slowdown, and might be hesitant to stop inflation at all costs," said Cantor Fitzgerald's Herrmann.

Still, his sensitivity to deflation and depression could be just what the economy needs if the housing market should get hit by a big slump, Herrmann said, because he his expertise is in negative economic events.

"Trying to fine-tune monetary policy for the largest economy in the world is never going to be an easy job," said Bohlin. "The challenges facing him have more to do with overall market challenges, and we'll have to wait out the uncertainty."

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