Bernanke: The Dilemma Ahead

While the housing slump drags on, the Fed chief says inflation is the bigger risk. Translation: Don't expect rate cuts soon

For quite a while, it looked as if the U.S. housing slump would be Topic A for the Federal Reserve this year, as overall economic growth moderated and inflation remained (mostly) in check. Financial markets appeared to be betting on possible interest rate cuts later in the year. But that assessment has been turned on its head in recent days, following some stronger-than-expected numbers on employment and business activity—and statements from Fed chief Ben S. Bernanke on June 5.

The Fed chief hardly downplayed the severity of the housing recession. Indeed, he admitted that the slump is going to last longer than the Fed previously thought in a speech made via satellite to the International Monetary Conference. But Bernanke thinks weakness in the sector shouldn't keep the rest of the economy down. The Fed chairman said the central bank remains focused on inflation, as "risks remain to the upside." The remarks appeared to catch financial markets off guard, sparking an 81-point drop in the Dow Jones industrial average June 5.

Housing Concerns: Not as Great?

Housing has been a top concern for the Fed's economic outlook in recent quarters as policymakers looked for signs that a sharp decline in homebuilding, falling home sales, and retreating home prices could lead consumers to stop shopping and businesses to rein in hiring and capital spending. Those concerns appear to be dissipating. In his June 5 remarks (see, 6/5/07, "Remarks by Chairman Ben S. Bernanke"), Bernanke stated that "we have not seen major spillovers from housing onto other sectors of the economy," and he expects the economy to start picking up with growth approaching the economy's trend rate—which economists believe is around 3%—by the end of the year.

Even though the Fed chairman expects the housing recession to linger, his stated expectations for growth imply the sector will not keep contracting at the 15% to 20% pace of the past three quarters. Indeed, based on the early second-quarter data, there are further signs that the drag from housing is easing (see BusinessWeek, 6/11/07, "U.S.: Is the Housing Recession Starting to Recede?". In fact, economists at JPMorgan Chase (JPM) believe homebuilding activity in the second quarter could fall just 8%.

The Economists Go Scurrying

At the same time, economic growth outside of housing is looking stronger than expected. The May employment report beat expectations, and firmer job markets should help to fuel solid consumer spending in the face of higher gasoline prices (see, 6/1/07, "A Merry May for Jobs"). Plus, the Institute for Supply Management's May reports on factory and service-sector activity show a healthy pickup in business and increased demand from abroad.

The latest numbers sent economists scurrying to upgrade their forecasts for economic growth and monetary policy. In a June 5 research note, Goldman Sachs (GS) chief U.S. economist Jan Hatzius stated, "We are pulling the plug on our forecast of Fed easing in 2007." He also upped his forecast for second-quarter gross domestic product to 3%, from 2%, and to 2.5%, from 2%, for the third quarter. On June 4, Merrill Lynch (MER) chief North American economist David Rosenberg also took back his long-held forecast of impending interest rate cuts, saying he now expects the Fed to keep its interest rate at 5.25%.

It appears Hatzius and Rosenberg are not the only ones shifting their expectations on monetary policy. The yield on the two-year Treasury note has been on the rise in recent days and, according to Bloomberg Financial Markets, options trading in federal funds futures shows that an increasing number of investors are betting their money on a rate hike before yearend.

If the economy bounces back faster and stronger than previously expected, it could quickly use up any slack in the economy and pull down the unemployment rate. That would raise the risks of increased price pressures even as inflation remains higher than the Fed would like it be. So as the economy shows further signs of improvement, expect the Fed to put less emphasis on housing and maintain an even keener focus on inflation.

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