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New Fed chief Bernanke warns on inflation

Posted on: Wednesday, 15 February 2006, 15:58 CST

By Tim Ahmann

WASHINGTON (Reuters) - In his Capitol Hill debut as Federal Reserve chief, Ben Bernanke on Wednesday said the U.S. economy was running so near capacity that higher interest rates may be needed to quell the risk of inflation.

The Fed chairman appeared keen to establish credentials as an inflation "hawk" in his first extensive comments since taking office two weeks ago by stressing the need to keep price pressures contained.

"The risk exists that, with aggregate demand exhibiting considerable momentum, output could overshoot its sustainable path, leading ultimately -- in the absence of countervailing monetary policy action -- to further upward pressure on inflation," Bernanke told the U.S. House of Representatives Financial Services Committee.

Bernanke's testimony on the Fed's semiannual report to Congress on monetary policy pushed prices for U.S. government bonds down and lifted the dollar as investors braced for more rate hikes. Stock prices were flat.

"He is achieving what I consider to be his key objective in this testimony, which was to keep the market expecting higher rates," said economist Eric Green at Countrywide Financial in Calabasas, California.

The central bank has raised benchmark overnight rates to 4.5 percent in 14 steps and markets expect the Bernanke-led Fed to lift credit costs at its next meeting on March 27-28, with a good chance they will reach 5 percent by mid-year.

Bernanke, who appears before a Senate panel on Thursday, seemed comfortable and in command as he endured 2-3/4 hours of often pointed questioning.

He offered thoughts on topics ranging from wage inequality to terrorism insurance to the potential dangers mortgage market giants Fannie Mae and Freddie Mac pose to the U.S. financial system.

But he adhered to a pledge he made in November to avoid being drawn into budget debates.

"I just don't want to be injecting myself into the specifics of how to do that," he said, sidestepping one of repeated questions on how to cut the hefty U.S. budget gap.

ECONOMY ON TRACK

Bernanke said recent data, including a report on Tuesday that showed retail sales boomed in January, "suggests that the economic expansion remains on track" after a strong 2005.

But he warned that high energy prices and tightening economic conditions could push prices higher.

"The economy now appears to be operating at a relatively high level of resource utilization," Bernanke said, alluding to tight labor markets and diminishing slack at industrial firms.

The Fed on Wednesday said the amount of industrial capacity in use fell to 80.9 percent in January on a drop in utility output amid warm weather. But December's figure was revised higher and factory capacity use hit its highest level since July 2000.

Bernanke noted the Fed's policy-setting Federal Open Market Committee said on January 31 that further policy firming may be needed, adding this was "an assessment with which I concur."

But the new Fed chief, who took over from Alan Greenspan on February 1, also said the central bank had made "substantial progress" in raising interest rates to a more normal level.

"As a consequence, in coming quarters the FOMC will have to make ongoing, provisional judgments about the risks to both inflation and growth, and monetary policy actions will be increasingly dependent on incoming data," Bernanke said.

EYE ON HOUSING

While he underscored inflation risks, Bernanke also said high energy costs could weigh on growth and a possible slowdown in the housing market bore close watching.

Fed officials expect the economy to grow about 3.5 percent this year, about the same as in 2005, and 3 percent to 3.5 percent in 2007.

The jobless rate was expected to come in between 4.75 percent and 5 percent at the end of this year and next. The jobless rate fell to a 4-1/2 year low of 4.7 percent in January, but that data came after officials assembled their forecasts.

Core inflation was seen at 2 percent this year, just a touch ahead of 2005, and 1.75 percent to 2 percent in 2007.

Bernanke played down fears a housing slowdown could derail the economy and expressed confidence that demand from elsewhere would "pick up the slack."

"A leveling out or a modest softening of housing activity seems more likely than a sharp contraction, although significant uncertainty attends the outlook," he said.

He said a yield curve inversion in the U.S. bond market, where short-term rates are higher than long-term rates, did not signal an economic slowdown, as they have often in the past.

(Additional reporting by Glenn Somerville, Andrea Hopkins, Alister Bull, Mike Dolan, Kristin Roberts)

Source: REUTERS

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