New Fed Chief ‘Curse?’ Summers, Yellen Should Brace for Early-Term Crises

Whether it’s Larry Summers, Janet Yellen or another economist, the next chairman of the Federal Reserve will immediately be thrust into the delicate process of extricating the central bank from its most extensive intervention in history.

But what if that’s not even the most difficult task on the incoming Fed chief’s plate?

Ever-superstitious market veterans are highlighting the “curse of the new Fed chair,” which left Paul Volcker grappling with the 1979 Iranian Revolution and spiking inflation, Alan Greenspan with the 1987 stock-market crash and Ben Bernanke with the scariest financial crisis since the Great Depression.

“The changing of the guard at the U.S. central bank brings unexpected macro events to test the newbie,” Nicholas Colas, chief market strategist at ConvergEx, warned clients in a recent note introducing the notion of an early-term curse.

While no one knows for sure what future crises will emerge when Bernanke’s second term expires in early 2014, concerns continue to linger about China’s shadow banking system, political unrest in turbulent Middle Eastern countries like Egypt and potential asset bubbles in the U.S. following years of incredibly easy monetary policy.

“The Fed has shown itself to be the central banker of the world. The waters are not exactly calm right now so it’s more than likely that there will be some tests for the new Fed chief,” said Richard Sylla, an economist and financial historian at NYU.

Inflation Fighter

Geopolitical events are often the toughest ones to see coming. And that’s exactly what Volcker was forced to grapple with when President Carter handed him the keys to the central bank in August 1979.

The 1979 Iranian Revolution and hostage situation created shockwaves around the world, throwing the    U.S. and other countries into a political crisis and causing oil prices to spike as high as $37 a barrel in 1980 – a level they wouldn’t touch again until 2004.

Hurt by the energy-price surge and painful inflation, the U.S. fell into deep recession soon after Volcker took office. But the Fed fought back in dramatic fashion by raising interest rates to double digits. Historians today credit Volcker with successfully suppressing inflation.

“Volcker gets very high marks,” said Sylla. “That was the kind of medicine the American economy needed to bring inflation back down.”

Stock Market Crash of ‘87

When he left office in August 1987 Volcker passed the baton to Greenspan, who was appointed by President Reagan.

Barely two months later, the central bank faced an ominous new crisis: Black Monday, the stock-market crash on October 19, 1987, that wiped out an incredible 23% of the Dow Jones Industrial Average.

The meltdown, equivalent to a gigantic 3,500-point nosedive on today’s Dow, set off fears that a severe economic downturn would follow, just as it did after Black Tuesday in 1929 ahead of the Great Depression.

Yet the markets managed to close higher on the year in 1987, “thanks in part to Greenspan’s reassurances of financial liquidity in the days after the crash,” said Colas.

Great Recession

President George W. Bush tapped Bernanke, a former Princeton economist, to succeed Greenspan in 2006, just as the housing market was beginning to show serious cracks.

“He got all of an 18 month reprieve from the ‘curse’ before it became clear that his predecessor might have been a little too heavy handed serving from the punch bowl of monetary policy,” said Colas.

Like many other regulators, Bernanke, a student of the Great Depression, was slow to recognize the threat the cratering housing market posed.

“The impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained,” Bernanke infamously told lawmakers in March 2007, just month before a pair of Bear Stearns hedge funds blew up.

But once the existential threat became clear to Bernanke, he moved swiftly (and controversially) to prevent a total collapse of the financial system by slashing rates to virtually zero for the first time ever and more than tripling the Fed’s balance sheet to beyond $3 trillion.

“He did things that surprised a lot of us because they were very bold,” said Sylla. “If there’s going to be a hero to this thing as we come out of it, I think we’re going to more and more appreciate what Bernanke did.”

Now What?

Bernanke’s place in history may ultimately be decided by his successor, who will have the unenviable task of shrinking that bloated balance sheet in a way that neither causes an inflation spike nor a fresh recession.

Yellen is still seen as the front-runner by economists in the race to replace Bernanke. Twenty-six out of 39 economists surveyed by Reuters this week picked Yellen, the current Fed vice chairman, as the most likely candidate.

But perhaps concerns about an early-term crisis have fueled the White House’s strong consideration and defense of Summers as the next Fed chief.

While Yellen’s nomination would be seen as a continuation of the policies embraced by Bernanke, Summers is the candidate with the most crisis-fighting experience on his resume. A veteran of the Clinton administration, Summers played key roles in the Mexican default and Asian currency crisis of the 1990s.