Bernanke Signals Further Rate Cuts

The Fed chairman's testimony to Congress indicated that concerns about a slowing economy still outweigh inflation worries

By Action Economics, S&P MarketScope, and BW staff

With the Federal Reserve trying to navigate a challenging course between slowing growth and rising inflation, the central bank's chairman tried to address the twin dilemmas in his semiannual monetary policy testimony before Congress on Feb. 27. The verdict from Fed watchers: Fed Chief Ben Bernanke steered his testimony toward the "dovish" side, placing greater emphasis on the central bank's need to shore up economic growth via monetary policy.

Indeed, Bernanke clearly left the door open for further Fed easing as he noted that downside risks to growth remain the main threat, reports Action Economics. While his testimony featured several paragraphs on inflation, he concluded that the Fed will be "carefully evaluating incoming information…and will act in a timely manner as needed to support growth and to provide adequate insurance against downside risks."
Fed Remains Focused on Growth

The term "adequate" is a major departure from the use of "substantive" when Fed officials presaged their January rate cuts, says Action, and "this suggests to us a less aggressive policy course, at least in March, unless we get a big downside surprise in the employment report."

"[T]here was no indication of a more hawkish message in response to signs of a buildup in inflation pressures," wrote Morgan Stanley (MS) economist David Greenlaw in a Feb. 27 note. "Instead, the Fed remains primarily focused on the downside risks confronting the economy and is leaving the door wide open for as much additional easing as is necessary to support growth."

Bernanke reiterated the downside risks to the economy, noting that the economic situation has become "distinctly" less favorable since July's Monetary Policy Report.
Keeping an Eye on Inflation

In noting inflation risks, Bernanke said the "further increases in the prices of energy and other commodities in recent weeks, together with the latest data on consumer prices, suggest slightly greater upside risks to the projections of both overall and core inflation than we saw last month." Bernanke said an increase in inflationary risks could complicate the central bank's ability to continue cutting borrowing costs to help underpin economic growth.

Bernanke acknowledged there may be some pass-through of energy costs to core consumer prices. But the core consumer price index is still expected to come in at a 2.1% rate this year. The key assumption, he indicated, is that energy and food prices would begin to flatten out, which so far has not been the case. That could lead to an "unmooring of inflation expectations"—some erosion in the Fed's inflation-fighting credibility—complicating the task of sustaining price stability and reducing the Fed's flexibility.

As for near-term policy, he said the Fed will need to judge whether the rate cuts to date are having the intended impact, and that the policy stance must be determined in light of the medium-term outlook, where downside risks remain.

Commenting on monetary policy, Bernanke said a critical task for the Federal Reserve over the course of this year will be "to assess whether the stance of monetary policy is properly calibrated to foster our mandated objectives of maximum employment and price stability in an environment of downside risks to growth, stressed financial conditions, and inflation pressures."

"In particular, the FOMC will need to judge whether the policy actions taken thus far are having their intended effects. Monetary policy works with a lag. Therefore, our policy stance must be determined in light of the medium-term forecast for real activity and inflation as well as the risks to that forecast."
Expect a 50-Basis-Point Cut

As for other key challenges to the U.S. economy, Bernanke said a lingering housing market slump and a related credit squeeze sweeping the financial markets were continuing to pressure the economy, resulting in a "distinctly less favorable" economic situation. Bernanke said economic growth had "slowed sharply" during the fourth quarter of 2007 and said the country's job market had "similarly softened."

"Although the words stagflation and recession appear nowhere in Bernanke's testimony, the discussion of downside risks to the growth outlook and upside risks to a higher inflation outlook have both a stagflationary and potentially recessionary feel about them," wrote Bear Stearns (BSC) economist John Ryding in a Feb. 27 note. "With the Fed in a growth risk management mode, we continue to look for a 50-basis-point rate cut on Mar. 18 (which is more than fully priced in after this testimony) and for two further quarter-point insurance rate cuts in April and June, putting the funds rate at 2% by midyear."

"The absence of an expression of stepped-up concern regarding inflation risks can presumably be interpreted as validation of the market's expectation of a [half-percentage-point] rate cut at the Mar. 18 FOMC meeting," said Morgan Stanley's Greenlaw.

But while Ryding, Greenlaw, and other economists believe the Fed will cut rates by 50 basis points on Mar. 18, Action Economics believes it's not clear that aggressive easing will be forthcoming at the March policy meeting. Action expects a quarter-point cut in the Fed funds rate target, to 2.75%, on Mar. 18.

[link to www.businessweek.com]