Bernanke's Precarious Position

The Fed's in a tricky spot as it tries to bolster growth while maintaining its inflation-fighting credibility

Ben Bernanke's appearance before a Senate panel on Valentine's Day wasn't greeted affectionately on Wall Street. The Fed chairman's pointed update on the Federal Reserve's current thinking on the economy and financial markets on Feb. 14 before the Senate Committee on Banking, Housing & Urban Affairs put a damper on both stocks and Treasuries.

Bernanke was joined by Treasury Secretary Henry Paulson and Securities & Exchange Commission Chairman Christopher Cox, and the three were fairly consistent in forecasting slower, but not negative, growth, with a downside bias. Bernanke plainly noted: "In part as the result of the developments in financial markets, the outlook for the economy has worsened in recent months, and the downside risks to growth have increased."

After carefully detailing recent developments in the credit markets, including troubled bond insurers and tightening credit conditions, along with the "softening" in the employment sector, Bernanke gave a cautiously optimistic spin to the economic outlook: "At present, my baseline outlook involves a period of sluggish growth, followed by a somewhat stronger pace of growth starting later this year as the effects of monetary and fiscal stimulus begin to be felt."

Focused on Tightening Credit Markets

And yet he acknowledged the risks to that outlook: "Although the baseline outlook envisions an improving picture, it is important to recognize that downside risks to growth remain, including the possibilities that the housing market or the labor market may deteriorate to an extent beyond that currently anticipated, or that credit conditions may tighten substantially further."

From the outset, Bernanke focused on the tightening credit markets, which have offset some of the Fed's policy easings. He appeared keen to demonstrate the Fed's fluency with these problems, which have gathered fresh momentum amid seizures in the auction-rate securities markets. Bernanke noted that "bank balance sheets have swollen," reducing banks' ability to extend fresh credit as they focus on strengthening their balance sheets.

He pointedly mentioned the boomerang effect from the bond-insurance sector and the tightening lending standards evident in the Fed's Senior Loan Officer Survey, which "seems likely to continue to be a source of restraint on economic growth." Along with labor-market softening, the credit markets have stoked the Fed's concerns about downside risks to growth despite its view that growth should improve later this year.

Central Bank's Continuing Role

Bernanke made no attempt to sugar-coat recent economic developments, especially on the employment front: "Conditions in the labor market have also softened. Payroll employment, after increasing about 95,000 per month on average in the fourth quarter, declined by an estimated 17,000 jobs in January. Employment in the construction and manufacturing sectors has continued to fall, while the pace of job gains in the services industries has slowed. The softer labor market, together with factors including higher energy prices, lower equity prices, and declining home values, seem likely to weigh on consumer spending in the near term."

In keeping with the Fed's dual mandate on growth and inflation, Bernanke did not surrender the central bank's important role in containing the latter. He cited the "steep runup" in energy prices, an "exceptionally rapid" rise in the price of food, and the weakness of the dollar as contributors to the rise in personal consumption expenditure (PCE) prices from 1.9% in 2006 to 3.4% in 2007, though core PCE prices—which exclude food and energy—grew by 2.1%, which is closer to the Fed's unofficial target zone of 1% to 2%.

Indeed, he said that though "inflation expectations appear to have remained reasonably well anchored, any tendency of inflation expectations to become unmoored, or for the Fed's inflation-fighting credibility to be eroded, could greatly complicate the task of sustaining price stability and reduce the central bank's policy flexibility to counter shortfalls in growth in the future." Bernanke said the central bank will closely monitor inflation expectations.

Not As Hawkish As Expected

Market rumors of more hawkish testimony from Bernanke were not borne out, providing some support to fed funds futures, an investing vehicle based on the future direction of interest rates. Yet, futures still imply some 50 basis points in additional rate cuts by the end of April.

Equities struggled on Feb. 14 with the dour growth outlook and more carnage in the financial sector after UBS's (UBS) large writedowns and a Moody's (MCO) downgrade of bond insurer FGIC. The dollar retreated after earlier gains sparked by rumors of a hawkish Bernanke.

The Fed chief was careful to balance his optimism the economy would narrowly skirt recession against the central bank's commitment to its "risk management" approach, to hedge against the self-reinforcing credit market cyclone. Bernanke added that the Federal Open Markets Committee "will be carefully evaluating incoming information bearing on the economic outlook and will act in a timely manner as needed to support growth and to provide adequate insurance against downside risks."

Risks of Overstimulating

It is evident the Fed will continue to wrestle with downside risks to growth and maintaining its inflation-fighting credibility, heading into the next significant policy intersection—the Fed's semiannual Monetary Policy Report to Congress on Feb. 27-28, just before the key February employment report. With the next FOMC meeting scheduled for Mar. 18, every available piece of economic evidence between now and then will be closely scrutinized.

It is our belief, based on currently available evidence, the Fed may hold fire until that meeting and cut by a smaller quarter-point margin when the time comes, as the risks of overstimulating the economy begin to outweigh the benefits.

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