Bernanke's Happy Honeymoon
Call it a solid rookie performance. Newly minted Federal Reserve Chairman Ben Bernanke provided a refreshingly lucid -- and mostly as-expected -- monetary policy report in his first semiannual testimony before the House Financial Services Committee on Feb. 15. (Bernanke will appear before a Senate panel on Feb. 16.)
The Fed chief and the House panel members who quizzed him after he read his prepared testimony were mutually respectful for the most part, though a number of House members could not resist an attempt to politicize the testimony. Bernanke made sure to tread very carefully while offering well-considered answers to pointed questions on wage inequality, housing, trade with China, the yield curve "conundrum," the current account gap, tax policy, etc.
A LITTLE TIGHTER?
It seemed clear that Bernanke is enjoying a brief honeymoon with legislators -- one that may last only as long as the U.S. avoids missteps into another financial crisis.
Overall, Bernanke was upbeat on U.S. economic growth prospects after overcoming the twin obstacles of higher energy prices and impact from the late summer 2005 hurricanes, which dented fourth-quarter GDP sharply, but set the stage for a rebound into 2006.
This bullish view holds at least right up to the point that a "high level of resource utilization" becomes an issue and output risks "overshooting its sustainable path." With this risk in mind, he endorsed the Federal Open Market Committee's Jan. 31 statement that "some further firming of monetary policy may be necessary." He also stated that future Fed decisions are "increasingly dependent" on data, though the Fed will be flexible in its decisions.
Bernanke introduced a note of hawkishness into the proceedings, warning that inflation this year is likely to run at the high end of the Fed's forecast range, though "longer-term inflation expectations appear to have been contained." While noting that inflation pressures increased last year, the Fed's favored measure of core personal consumption expenditure (PCE) prices "at just below 2% remained moderate."
Yet risks to the bullish outlook are from rising energy prices, a slowdown in the housing market, the rising deficit, and some structural weakness in several areas of the economy and the auto and aircraft industries.
Accordingly, the Fed's central tendency forecasts -- its projections for economic growth and inflation issued in conjunction with the Fed chief's appearance -- showed real (adjusted for inflation) GDP "about 3½%" for this year, and a 3% to 3½% range for 2007. The core PCE price index is seen "about 2%" this year, and 1-3/4% to 2% next year. The unemployment rate is seen at 4-3/4% to 5% this year and in 2007.
We at Action Economics suspect the Fed's growth forecasts may be low-balled relative to our own quarterly forecasts. Nevertheless, the Fed's estimates suggest that with growth steady, inflation peaking, and unemployment low, another one or two quarter-point rate hikes may be in the cards. Indeed, financial markets appear to be pricing in such a scenario.
Bernanke delved into a recap of the yield curve "conundrum," in which policy tightenings have failed to bring about an increase in long-term yields, and he suggested that the inverted curve (in which short-term rates rise above long-term rates) does not necessarily indicate a recession is on the horizon. He mentioned the usual arguments of lower risk premiums given Fed policy credibility, rising global savings, and demand for long-term securities from entities like pensions and life insurers.
On another hot-button subject, Bernanke noted "a number of indicators point to a slowing in the housing market," though some cooling in the sector was not inconsistent with continued solid growth in the economy overall. The housing trends bore watching along with risks from higher energy prices, which could also dent consumer confidence because of higher gas and heating oil bills. Moreover, Bernanke saw historically low mortgage rates and rising household wealth as supportive of the sector, with a decline in personal savings a temporary factor.
ENERGY'S DIMINISHED CLOUT.
Bernanke clarified the Fed's views on wage growth, suggesting that the Fed was concerned about the increase in wages above the rate of inflation, though rises in "real wages" were healthy. Otherwise, he agreed that it was important to avoid income inequalities. The Fed did notice that education levels largely determined future earning power and therefore education should be emphasized to reduce this gap.
Overall, we think he did a commendable job of avoiding the pitfalls of politicizing these issues in response to some rather pointed questions. He also favored a research and development tax credit, given the importance of R&D on future economic growth.
Turning to another key topic, Bernanke noted that energy-price increases have not translated into a outsized jump in inflation, wages and prices, suggesting that the economy is less dependent on energy than previously.
FIRM AND STEADY.
He expected oil prices to remain high for now, given global supplies being close to capacity. Echoing his predecessor, he said that high prices would help encourage alternative energy sources 10-20 years down the road, though we will have to live in a "zone of vulnerability" for the next 5 years to 10 years.
On the current account deficit, he noted that it was a concern as imbalances grow, but expected that in the longer-term these should be self-correcting and will decline over time. That said, he noted that it would be undesirable for a rapid adjustment in the deficit, which could be disruptive to the economy, though he did not see that as a likely event.
He also recognized that global growth appeared to be strengthening, with Canada and Mexico expanding solidly and "especially significant" that Japan appeared to be emerging from its slump and its bout with deflation.
"A DIFFICULT BALANCE."
Bernanke saw the eurozone recovering, Asia growing strongly, and China booming. The trade deficit was growing partly due to the high dollar cost of energy prices and imports, while the past strength of the dollar helped contain inflation.
The Fed chief also paid tribute to Greenspan and hinted at continuity at the Fed by referencing the former chair's "risk management" approach to policymaking. He noted the limits of macroeconomic models which did not take fully into account the full breadth of economic and financial data.
In this regard, "monetary policymakers must therefore strike a difficult balance -- conducting rigorous analysis informed by sound economic theory and empirical methods while keeping an open mind about the many factors, including myriad global influences, at play in a dynamic modern economy like that of the U.S."
The rookie Fed chief also addressed the issue of transparency at the central bank. Bernanke hopes to be more open about Fed strategies and how it sees the economy. He suggested that "fresh air is good," noting that more openness will add to accountability of policy and that it will add to credibility of policy and make it more effective.
Bernanke wants to continue in that direction, with possible moves including a long term inflation target. So while the Bernanke Fed's monetary policy is expected to hew close to that of his predecessor, he may just put his own stamp on the central bank in other ways.