U.S. financial markets will judge the success of the transition to a new Federal Reserve (search) chairman in the next three months by how well President Bush's nominee, Ben Bernanke (search), responds to rising inflation.
Bernanke, the White House economic adviser and a former Fed governor, calmed markets immediately after being nominated on Monday to replace current chairman Alan Greenspan (search) by saying continuity at the Fed was critical.
That suggested to many in financial markets that he would likely continue raising interest rates to combat rising inflation.
But some also feel that Bernanke's past focus on inflation targeting means he still has to prove his inflation-fighting credentials to the bond market.
"The bottom line is that he (Bernanke) has been wrong about what's been happening with inflation for two years," said Josh Stiles, senior bond strategist at IDEAglobal in New York.
"He's more focused on the structural disinflation forces than he is on the cyclical inflationary forces from excessive accommodation," Stiles said.
The benchmark 10-year Treasury note (search) yield was at 4.44 percent shortly after Bush's announcement, up from 4.39 percent late Friday, reflecting mild fears a Bernanke-led Fed might not fight inflation aggressively enough.
Despite slightly higher U.S. bond yields, the dollar also slipped.
"I think the knee-jerk reaction on Bernanke's nomination was to sell the dollar, since he has a reputation of being a dove when it comes to monetary policy," said Paresh Upadhyaya, portfolio manager with Putnam Investments in Boston.
Bernanke's "chief objective will be to build his credibility, and therefore I would not expect a change in the Fed's monetary policy," Upadhyaya said.
"So any sell-off in the dollar we might have seen ahead of and after the nomination should be short-lived, and the dollar may resume its upward bias as it becomes clear that Fed policy will not change," Upadhyaya said.
Interest rates may not have reached their peak in the current monetary policy tightening cycle by the time Bernanke takes over the reins from Greenspan. Analysts expect the federal funds rate to rise to at least 4.25 percent by the time Greenspan retires as chairman of the Fed on Jan. 31.
With record energy prices fueling inflation in a way not seen since the 1970s and concern about a house price bubble also in focus at the Fed, Bernanke is seen having his work cut out for him.
"You've got energy inflation, you've got a question mark over goods inflation and you've got a question over asset inflation as to whether the cycle is turning," said Alan Ruskin, research director at 4Cast Ltd. in New York.
"We are at an interesting point in the business cycle. All these issues have major ramifications in terms of guiding the path going forward. There is definitely uncertainty over these issues," Ruskin added.
"The No. 1 job will be fighting inflation," said Joe Quinlan, chief market strategist at Banc of America Capital Management in New York.
"It seems to me (Bernanke) will want to raise interest rates very early in his tenure ... partly because of the transition, and partly because of when the transition takes place," said Marc Chandler, a partner with Terra K Partners, a New York financial consultancy.
Currency market players are mostly concerned about whether Greenspan's departure will alter the pace or magnitude of Fed interest rate rises, which have helped boost the greenback 11 percent against both the euro and the yen in 2005.
Whatever the anxieties about the transition and the challenges, many in the market feel the institution is bigger than the individual. That means Bernanke is likely to make a mark at the Fed, but not right away.
"People who know Bernanke and who've read him pretty much know where he stands. I think he's a straight shooter," said Andrew Brenner, head of fixed income at Investec US. "He won't have the relationships with other central bankers Greenspan had. That's just going to take time to build."