Behind Bernanke's Picture Perfect Forecast

The Fed still frets that inflation won't behave as policymakers expect

In an era when one of the Federal Reserve's top priorities is better communication with the financial markets and more transparency in its policy-setting process, the Fed's semiannual forecasts for the U.S. economy remain one of the more confusing aspects of monetary policy. Are they really forecasts, based on the policymakers' best judgments of the future, or are they loosely defined targets, showing what the Fed would like to achieve? Economists think the prognostications contain enough of the latter to act as a guide to possible changes in interest rates if reality takes a different course.

That's why it's worth taking a close look at the Fed's latest forecast in its Monetary Policy Report to the Congress, delivered by Fed Chairman Ben Bernanke in his testimony on July 18-19. The projections for 2007 and 2008 are a central banker's dream. They show moderate economic growth that's slow enough to assure inflation will be in the Fed's comfort zone next year but fast enough to hold the unemployment rate only a pinch above its current low level. In a scenario like that, the Fed could go on vacation from now through all of next year.

The forecast implies the economy will grow at, or a tick below, its long-run trend. That's a pace consistent with keeping inflation under control, because it prevents labor markets from becoming too tight, and it keeps pressure on production capacity from building. Of course, as Bernanke noted, the growth projections "are conditioned on the assumption of appropriate monetary policy." That is, they don't tell us what shifts in interest rates might be needed along the way. Higher-than-expected growth or inflation could provoke a rate hike, while undershooting might trigger a rate cut.

ALREADY, THE FED HAS SEEN some small deviations from its previous forecast, issued with its last policy report back in February. The current projection for growth in 2007 is now a quarter-point lower than before. That reflects the economy's sluggish 0.7% annualized pace in the first quarter.

For 2008, the policymakers expect the economy to pick up a bit, as the housing drag lessens, and they see inflation outside of energy and food easing, from an expected 2% to 2.25% in 2007, to 1.75% to 2%, based on the Fed's preferred price measure. Inflation has proven a bit tamer so far this year. That gauge fell to 1.9% in May, and it now lies in the 1% to 2% comfort zone of most policymakers for the first time in more than three years.

Even so, based on Bernanke's testimony, the Fed continues to believe the biggest risk to its forecast is higher inflation, not a weak economy. Prior to the slowdown in the Fed's price gauge, the policymakers said their biggest concern was that inflation would not moderate as expected. Now, despite tamer inflation readings, Bernanke says a sustained moderation in inflation pressures has "yet to be convincingly demonstrated."

Why the persistently tough talk? Bernanke and other policymakers are most keenly focused on the already tightly wound labor markets and the inflation pressures they could generate. As a result, the Fed Chairman's hawkish words put attention squarely on the central bank's forecast for economic growth and how the economy's pace will influence the unemployment rate.

How The Fed Views The Outlook
On that front, the Fed's forecast for economic growth this year looks somewhat at odds with its expectation for unemployment. The projection that the economy will grow 2.25% to 2.75% from the end of 2006 to the end of 2007 implies that growth in the second half of this year will be in the range of about 2.5% to 3%, assuming an expected rebound in second-quarter growth. However, the economy has grown only a bit over 2% during the past year, and the jobless rate has actually edged lower. If second-half growth comes in at the high end of the Fed's range, the jobless rate would likely fall even further, creating more concern over potential wage and price pressures.

THE FED'S PROJECTIONS also highlight a new criticism that has cropped up recently: The central bank's inflation forecast focuses on core inflation, which omits energy and food, while ignoring overall inflation. Although the core inflation using the Fed's preferred index has fallen within the 1% to 2% comfort zone as of May, overall inflation for that same index is running at 2.3%. The same pattern is true for the more popular consumer price index. Through June, the core CPI is up 2.2% from a year ago, but the total index is up 2.7%, reflecting the high inflation rates for food (4%) and energy (4.6%). Bernanke addressed this issue in his testimony and in a recent speech.

Policymakers defend this choice by noting they cannot control short-term ups and downs in energy and food prices, which are usually subject to weather and other supply conditions both at home and abroad. But try telling that to the folks on Main Street. Those two items make up about 20% of consumer spending.

The Fed Chairman and nearly all economists believe fluctuations in energy and food prices can exert a lasting effect on inflation only if they pass through to other prices and ultimately alter consumer and business expectations of inflation. If people begin to anticipate rising prices, they will work those expectations into their pricing and wage behavior, thus setting off the classic wage-price spiral. But if expectations are held in check, other prices adjust, offsetting the overall impact, as budgets get squeezed and spending patterns change.

THE IDEA OF ASSURING investors that long-term inflation expectations remain firmly in check is central to Bernanke's theory of how sound monetary policy should be practiced. He laid out these ideas in great detail in a speech on July 10, most likely in a pointed effort to explain the Fed's focus on core inflation. He allowed that various data showed inflation expectations were well anchored--at least enough to believe that overall inflation will ultimately converge to the core rate.

How Energy And Food Affect Inflation
However, he also noted that expectations were not perfectly anchored, since they still fluctuate. That's one reason Bernanke & Co. continue to give heavy weight to the risk that inflation will not stay down in the face of costlier energy and food. Bernanke has long argued that a more perfect anchoring can be achieved by the Fed adopting an explicit inflation target. Such a target, he believes, would make the economy even less vulnerable to short-term swings in energy and food prices.

All this is why the Fed's semiannual forecast could eventually play a central role in policy communication and transparency. If these forecasts, especially the one for inflation over the long term, are seen as objectives for policy to achieve, then the Fed can more publicly and clearly anchor inflation expectations.

Fed discussions of possible targeting strategies are still ongoing, and any decision remains a ways off. But until then, if you believe the Fed will act to ensure its latest inflation forecast comes to fruition, then you have no reason to expect inflation to be anything but tame.

By James C. Cooper

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