Bernanke's Steady Course Cheers Markets

The Fed gave rates another breather at its Sept. 20 meeting. Still, no one's sure how smooth the landing will be

Fed chief Ben Bernanke may earn his wings yet, as he attempts to pilot the U.S. economy to a soft landing. On Sept. 20, the Federal Reserve's interest rate-setting committee took one step toward that goal when it left overnight lending rates at 5.25% for the second meeting in a row, relying on a slowing economy to bring down inflation.

Among the 11 current members of the group, Richmond Fed President Jeffrey Lacker was the only dissent, voting to increase rates by 25 basis points.

Financial markets appear to raising their bets that the new Fed chief will be able brake the economy enough to bat down inflation without slumping into a recession. The Dow Jones industrial average rose 72 points on Sept. 20, and the yield on the 10-year Treasury Note declined slightly, to 4.73%.


  But the economy could end up hitting the ground with a thud rather than drifting along a feather-light downdraft as it suffers the effects of the Fed's 17 previous rate hikes since June, 2004, and the recent sharp correction in the housing market. Gross domestic product growth could fall from 2.9% in the second quarter this year to 1.5% next year, according to Capital Economics. Still, Chamber of Commerce Chief Economist Martin Regalia bucks up Bernanke with an aphorism from the crop-dusting business: "Anytime you can walk away from it, it's still a pretty good landing."

With an economic descent in store, economists seem to agree that the Fed will hold rates steady at least through the first half of 2007 and start cutting by late next year. Some forecasters predict that the economy will begin to show signs of new life next year. So far, the weakness in the economy is centered on the housing downdraft, declining auto sales, and a widening trade deficit. Soon, other engines of growth are likely to kick in.

Easing energy prices and interest rates will give consumers a boost, closing the hole in the pocket caused by the housing correction. And business investment is picking up. "…There appears to still be considerable resilience elsewhere," wrote Laurence Meyer of Macroeconomic Advisers in a Sept. 15 report.

Still, for all the economic slowing ahead, lone Fed dissenter Lacker may be onto something. The sentiments behind his negative vote—a sign that Bernanke is tolerating more open dialogue on the policy-setting Federal Open Market Committee—are echoed in the statement released by the FOMC after the Sept. 20 vote.


  The committee left unchanged a bias towards interest-rate tightening. With the same language used from the statement after the June meeting, when the Fed last raised rates, the FOMC said: "…some inflation risks remain" and "the extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information." Indeed, core consumer prices—excluding food and energy prices—are likely to exceed the 2% upper limit that many Fed members have identified as their comfort zone for inflation.

Month by month, Bernanke & Co. are still feeling their way through the evolving economic data. But now the field ahead looks clearer, as the Fed's pilot tries to engineer a smooth landing for the world's largest economy.

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