Drawing a Bead on Bernanke
Since Federal Reserve Chairman Ben Bernanke's last semiannual monetary policy testimony before Congress in February, the economic outlook improved while the inflation outlook didn't, and housing's decline moderated, with the sector's slowdown still not having a significant impact on economic growth. At his July 18-19 testimony, the chairman will likely adhere to the same sober tone on inflation taken in the last Federal Reserve policy statement.
The solid labor market has certainly been a welcome trend since Bernanke's February appearance. Persistent strength in payroll growth, on average, has been the biggest upside surprise for the economy, as the moderation in payroll gains to a 145,000 monthly average, from 189,000 in 2006, reflects little more than the expected correction to last year's outsize gains, with virtually no sign of labor market weakness. The monthly pattern of continued job market tightness has been confirmed by virtually all other labor market indicators.
Beyond job strength, the monthly retail sales, trade deficit, and industrial production reports have helped diminish downside economic risk. On the negative side: Weakness in durable-goods orders in January and February that has yet to be fully mitigated by ensuing gains, and the lean first-quarter GDP growth figure for which the ensuing second-quarter rebound has yet to be confirmed with the advance report.
The inflation figures have sent a more ambiguous signal, as headline and core (excluding food and energy) figures were stronger than expected in the months just after the Feb. 14 testimony, but have since shown moderating core gains. Yet, the Fed is likely looking at the bigger picture of price indicators, and it is here that the Fed's recent boost in inflation concerns likely sits. The year-over-year core inflation figures as gauged by the monthly CPI reports—we will get the June update on July 18, just prior to the start of day one's testimony—have moderated in recent months toward the Fed's 2% "soft" target.
But, headline inflation has persistently outpaced core inflation, and the headline figures are now running remarkably hot even though the current year-over-year gains benefit from easy comparisons given the sharp commodity price drop-off last August and September. As the Fed staff is well aware, headline year-over-year gains will soar above 4% by November even if food and energy prices remain unchanged from current levels, and the path for the core figures will face associated upward pressure.
This concern is likely driving the Fed's reference in the last FOMC statement that "a sustained moderation in inflation pressures has yet to be convincingly demonstrated. Moreover, the high level of resource utilization has the potential to sustain those pressures."
The chairman will be working these concerns into his testimony, with potential references to headline inflation that may stir market rumors that the Fed is looking to target a headline figure. Of course, we doubt that the Fed would take such a step, but rumors such as these reflect the more useful observation that a tracking of headline inflation is an important part of the Fed's overall inflation assessment.
Real Estate Concerns
Finally, recent housing data have suggested that we will be seeing continued weakness in real estate indicators such as new home and existing home sales over the coming months as inventories are unwound, with associated weakness in housing starts. Yet, the downward path for price indicators from the real estate market appears to be losing some steam. And the monthly construction spending reports have posted steady gains from a January trough. Associated construction employment data confirm that robust growth in nonresidential, public, and home improvement activity has largely contained housing weakness to the single-family home segment.
So what does all this mean for the market's likely response to the chairman's testimony? The Fed funds futures market has largely priced out any risk of a Fed easing through the rest of the year, and we doubt the chairman will want to say anything that encourages the market to price in a Fed tightening at this time.
The more subtle risk, in our view, is that the chairman's propensity to work his inflation concerns into responses to Banking Committee questions will appear in contrast to the eagerness of committee members to discuss the more headline-grabbing topics of subprime and credit market woes. While legislators' questions will dwell on downside economic concerns, Bernanke's answers may shift toward upside inflation concerns.
Whether Bernanke will prove as adept as Alan Greenspan at answering these questions without saying anything to spook the markets has yet to be seen. But, we do know that Bernanke elaborates more than Greenspan on economic views, while also sticking to the script. And, in this regard, the boost in the Fed's inflation rhetoric in the last statement raises the risk that the market may not be ready for a word-for-word restatement of the Fed's official position from its last policy meeting, with associated elaboration.
For the Fed outlook, we think the market may be underestimating the potential for the statement at the August FOMC meeting to further raise the tone of Fed inflation concerns. Risks here depend on the inflation news in the upcoming PPI, CPI, and PCE chain price reports, as well as the July round of employment data and the second-quarter GDP data with its associated annual revisions. If we get significant upside surprises in any of these reports, and if the economic outlook continues to improve accordingly, the August statement may be reworded in a way that opens the door for an imminent Fed tightening.