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The Logic of Reappointing Bernanke

The big news from Martha's Vineyard is that Obama is appointing Ben Bernanke to a second term as Fed chairman. I've explained before why I think this is a good idea--Bernanke has been creative, even highly unorthodox, at precisely the moment when the economy demanded these qualities from the Fed, and when a conservative, by-the-book approach would have likely sent us into a depression. True, Bernanke's Fed didn't exactly distinguish itself on the regulatory side, particularly the consumer regulatory side, during the boom years--the Fed is by statute one of the nation's top consumer financial regulators. But that was the status quo Bernanke inherited from Alan Greenspan in 2006. And there wasn't exactly a ton of time between then and the onset of the financial crisis in 2007 to reorient the institution. (Which isn't to say Bernanke would have if he'd had more time, but still...)

Of course, that doesn't in itself explain why Obama chose to reappoint Bernanke rather than tap a Democratic-leaning economist like Larry Summers, Janet Yellen, or Roger Ferguson--all of whom could have made fine Fed chairmen. To get there, you have to understand the additional importance of continuity at the Fed. It matters in two key ways. First, it just takes a while for financial markets to understand a particular Fed chairman's idiosyncracies and ways of communicating (and, conversely, for a new Fed chairman to settle on the most efficient way of communicating with markets).

The markets have come to trust Bernanke's pronouncements about monetary policy in recent years. But that wasn't always the case. The first several months of his tenure featured a series of misunderstandings--none of them catastrophic, but all less than ideal. The most famous was Bernanke's comment to a congressional committee in April 2006 that the Fed might lay off raising interest rates at some point soon and gauge the state of the economy before resuming. The market interpreted this as a statement of clear intent, when in fact Bernanke meant it literally--he really didn't know whether or not the Fed would take a breather. When Bernanke then inadvertently clarified the statement--through a private, off-hand comment to CNBC's Maria Bartiromo, who subsequently shared it with the world--the markets briefly threw a fit. Not exactly the kind of kinks you want to be working through while trying to recover from the worst financial crisis since the Depression.

The second benefit of continuity is that it buys you room to maneuver. During the last several months, the Fed has massively expanded its role in the economy to keep credit flowing and prevent the financial system from seizing up. This is unquestionably a good thing (see the first paragraph above). But one side effect has been to create a vocal reaction among bond traders (and their economist-sympathizers), who fear the moves will be inflationary and are constantly pressuring Bernanke to unwind these policies as soon as possible.

Alas, doing so while the economy and financial system are so weak would be a horrible, self-defeating mistake--something Bernanke understands. But without Bernanke's track record and credibility, a new chairman might have to start unwinding the Fed's balance sheet much sooner to establish his/her anti-inflation bona fides. (Or, put differently, bond investors might actually start bidding up interest rates rather than just kvetching about inflation unless a new chairman sent a hawkish signal out of the gate.) Suffice it to say, the White House has very good reasons for wanting to avoid this outcome.