- The Washington Times - Saturday, March 31, 2007

To those in the financial markets who blithely ignored half the message — the more important half, by the way — in the press release issued March 21 by the Federal Reserve’s interest-rate policy committee, Fed Chairman Ben Bernanke delivered a blunt message Wednesday. During his appearance before Congress’s Joint Economic Committee (JEC), Mr. Bernanke effectively said: Read the press release again and take note. “In our statement, we said that our view was that the inflation risk was still predominant,” the Fed chairman, who prides himself on being open, confirmed to the committee. “And so, our policy is still oriented towards control of inflation, which we consider at this time to be the greater risk.” Just in case there was still any confusion, he quickly added, “I do want to emphasize that we have not shifted away from an inflation bias.”

For the first time since June, when the Fed paused after raising its target short-term interest rate from 1 percent in June 2004 to 5.25 percent two years later, the its March 21 press release did not include the words “additional firming.” That expression is “Fedspeak” for higher interest rates. Ignoring what else the Fed plainly said, the financial markets interpreted the absence of “additional firming” as a signal that the next Fed-instigated movement in short-term interest rates would be downward. Immediately — literally, immediately — stocks soared as the Dow industrials gained 160 points before trading closed less than two hours later. The Dow dropped 100 points last Wednesday after Mr. Bernanke reiterated the Fed’s position no fewer than three times within half a minute.

About the Fed’s position: Without incorporating the proverbial phrase in his prepared remarks or in his answers to questions, Mr. Bernanke nonetheless made it clear that the central bank now finds itself between a rock and a hard place. The Fed chairman told Republican Rep. Jim Saxton that the latest statement from the central bank’s monetary-policy committee “included a description both of the situation on the real [i.e., output] side of the economy and on the inflation side. And our sense was that the risks had increased on both sides.” He explained that “the outlook for output was a bit weaker” and “the inflation situation had become slightly riskier as well. And so both sides of the [Fed’s] mandate are facing somewhat greater risks.”

To be sure, Mr. Bernanke repeated the general thrust of the Fed’s February forecast. The Fed still expects the economy to “grow at a moderate pace” this year, and it expects “inflation to moderate gradually.” It’s just that the risks to both favorable transitions have increased since the Fed presented Congress with its semi-annual forecast on Valentine’s Day.

The housing situation, which has deteriorated significantly in recent weeks as the subprime mortgage market has imploded, remains the wild card. The subprime market, which has been hit by a wave of defaults and foreclosures, involves homebuyers with inferior credit histories, limited financial resources or both. After reporting in its Jan. 31 statement that “some tentative signs of stabilization have appeared in the housing market,” the Fed acknowledged on March 21 (following the subprime implosion) that “the adjustment in the housing sector is ongoing.”

JEC Chairman Charles Schumer, the senior Democratic senator from New York, asked Mr. Bernanke about “the perfect storm of lower home values and higher mortgage [interest] rates” and to what extent “the dumping of [foreclosed] empty homes on the market [would] affect overall housing supply and housing prices.” On both counts, the Fed chairman answered quite optimistically. “So far,” Mr. Bernanke said, the Fed hasn’t seen “any significant indications that [the subprime] problem has spilled over” into other portions of the mortgage market or other credit markets. Also, the Fed judges that subprime effects “will be moderate” on the overall housing market, and, “therefore, the effects on the economy overall should be relatively small.”

Meanwhile, business investment, which actually declined during the fourth quarter after increasing 14 quarters in a row, is problematic as well. Indeed, durable-goods orders, which are a good proxy for capital spending, plunged in January and only modestly improved in February.

The inflation front is even more complex. The 12-month increase in the overall consumer price index (CPI) has moderated from 3.6 percent in February 2006 to 2.4 percent in February 2007. However, the 12-month increase in the core CPI, which excludes energy and food, has sharply accelerated from 2.1 percent in February 2006 to 2.7 percent in February 2007. Explaining that core inflation represents “a better measure of the underlying inflation trend than overall inflation,” the Fed chairman told the committee that the level of core inflation “remains uncomfortably high.”

On an optimistic note, Mr. Bernanke speculated that consumer spending “might continue to grow at a brisk pace.” But he did not explain how this might occur if huge mortgage equity withdrawals, which annually financed hundreds of billions of dollars in consumption in recent years, were to come to a screeching halt in response to falling home values. And nobody asked.

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