July 16, 2008

Bernanke’s Dour Message

by BusinessWeek, Standard & Poor's, and Action Economics staff

Amid a plunging stock market, rising inflation, and widespread jitters about the U.S. financial system, what better time for Federal Reserve Chairman Ben Bernanke to deliver to Congress his semiannual testimony on the U.S. economy? In his July 15 testimony to the Senate Banking Committee, the Fed chief noted that inflation risk to the U.S. economy has intensified, but also emphasized downside risks to growth.

He said officials expect the economy to improve "gradually" over the next two years, thanks to a "slow" housing recovery and gradual improvement in credit conditions. But he warned that "considerable uncertainty" surrounded that outlook. He said the U.S. economy faces "numerous difficulties," suggesting those risks remain his top priority. He noted an "unusually uncertain" inflation outlook, and said the Fed is watching for signs that higher commodity prices are becoming embedded in wages and expectations.

Bernanke noted that "accurately assessing and appropriately balancing the risks to the outlook for growth and inflation is a significant challenge for monetary policymakers."

Searching for Signals About Rates "Overall, while there was no clear indication about when the [Federal Open Market Committee] might start to raise rates, given downside risks to growth and increased financial market turmoil, it doesn't look like there will be a rate hike anytime soon," wrote Standard & Poor's Senior Economist Beth Ann Bovino in a July 15 note.

"[T]he Fed continues to play down the risks of the pickup in inflation being sustained and [to suggest] that the hurdle to a rate hike in the second half of the year is very high," wrote economist John Ryding of RDQ Economics in New York in a July 15 note. "In particular, Bernanke's testimony suggests that the Fed is now relying on subdued domestic wage increases to restrain core inflation."

"We're not as sanguine as the market that the Fed won't start taking back some of its accommodation by the end of this year, especially considering the upward revisions in the Fed's outlook on inflation down the road," wrote Action Economics analysts in a posting on the company's Web site.

In a Q&A session with lawmakers after the testimony, Bernanke said the central issue that Congress should tackle is the housing market. He said the continued uncertainty over housing prices and housing activity is largely behind the financial market stresses, as well as stress in the economy.

Bernanke on Banks On other matters, Bernanke said he is still trying to assess the impact of the current fiscal stimulus package. Regarding gas prices and energy-market speculation, he said the Fed is looking at a whole range of issues regarding transparency. Bernanke cautioned lawmakers to move deliberately and cautiously with respect to trying to legislate against speculation. The Fed chief said he would not estimate that speculation or manipulation has been a "significant" part of the rise in oil prices. He warned against doing anything that would hinder or stop the futures markets from their legitimate functions of providing liquidity and serving as a means of hedging.

Bernanke said the failure of IndyMac Bank, which was seized by regulators July 11, was due to the poor asset quality of the bank, particularly weighted down by subprime and other exotic mortgages. He said that in general, banks came into the credit crunch "well capitalized." His concerns have turned more toward banks' ability to extend credit, and less on solvency issues.

On the government-sponsored enterprises Freddie Mac (FRE) and Fannie Mae (FNM), Bernanke said the Fed's goals are to protect the financial system, as well as taxpayers, and that a strong bank-like regulator for the GSEs is needed, one that can restore confidence in the system. Bernanke was to have an additional opportunity to weigh in on the Fannie/Freddie situation in joint testimony with Treasury Secretary Henry Paulson and Securities & Exchange Commission Chairman Christopher Cox later in the day.