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Fed Chief Optimistic on Inflation
by EDMUND L. ANDREWS
U.S. Senate Committee on Banking, Housing, and Urban Affairs
Jul 20, 2006 - New York Times - WASHINGTON, July 19 — Despite the recent acceleration in consumer prices, pushed higher largely by oil prices, the chairman of the Federal Reserve expressed optimism on Wednesday that the central bank’s heavy lifting to fend off inflation may be almost finished.

“The economy appears to be in a period of transition,” Ben S. Bernanke, the Fed chairman, said at a hearing of the Senate Banking Committee. The outlook, he said, is for somewhat slower economic growth, a slight increase in unemployment and a broad-based cooling of the nation’s housing market.

The comments by Mr. Bernanke, who got off to a somewhat rocky start with Wall Street earlier this year, helped fuel a rally in financial markets, which had already started the day up on strong earnings reports from I.B.M., banks and airlines.

The Standard & Poor’s 500-stock index climbed 1.9 percent and pushed its way back into positive territory for the year after falling 2.3 percent last week when hostilities flared in the Middle East. The Dow Jones industrial average was up 212.19 points and the Nasdaq composite rose 1.8 percent.

And even though the Labor Department reported Wednesday morning that consumer price increases in June slightly exceeded expectations, Treasury bonds recovered from their earlier losses and shot higher.

Mr. Bernanke left ample room for another rate increase when Fed policy makers meet on Aug. 8, but he suggested that the most recent jumps in consumer prices were largely old news and would gradually subside as the Fed’s previous rate increases rippled through the economy.

“The lags between policy actions and their effects imply that we must be forward-looking, basing our policy choices on the longer-term outlook,” Mr. Bernanke told lawmakers. “We must take account of the possible future effects of previous policy actions — that is, of policy effects still ‘in the pipeline.’ ’’

Mr. Bernanke offered no specific hints about whether the Fed would raise rates again at its next meeting, and many analysts predicted that at least one more increase was still likely.

Speaking carefully, and staying as close as possible to his prepared remarks, Mr. Bernanke displayed a new nimbleness in communicating — in contrast with earlier performances that seemed to confuse investors and rattle the markets.

In plainer language than that typically used by his predecessor, Alan Greenspan, Mr. Bernanke conveyed a clear message on Wednesday about the Fed’s thinking. But he avoided any explicit hints about the Fed’s next policy move and emphasized the need for toughness if inflation signs unexpectedly persist.

Boiled down, Mr. Bernanke conveyed a twofold message: The economy appears to be reacting to Fed policy as expected, which means that interest rates probably do not need to climb much higher — but if there are any surprises, all bets are off.

“We think this is a pretty clear signal that Mr. Bernanke does not think the recent inflation numbers ought to have much impact on the debate,” wrote Ian Shepherdson, an economist at High Frequency Economics, in a note to clients. “The key question is whether the tightening already in place is enough to slow the economy to a pace that will, over time, reduce inflation pressure. Mr. Bernanke thinks it is.”

In his testimony, the Fed chairman admitted that inflation was higher than the central bank had expected back in February. But he suggested that inflation would gradually subside in 2007 to just above the central bank’s informal comfort zone.

The Fed’s newest forecast anticipates that the nation’s economic growth will slow to an annual rate of about 3 percent this year and next — down from the red-hot pace of 5.6 percent in the first three months of this year — and that the underlying “core” pace of inflation will edge down to about 2.2 to 2.3 percent next year from an average around 2.5 percent this year.

Core inflation, excluding the volatile prices of food and energy, would still be higher than Mr. Bernanke’s preferred target of 1 to 2 percent and higher than the Fed had previously expected. But the trend would be in the right direction, and Mr. Bernanke has often cautioned against knee-jerk reactions to temporary shocks.

On Wednesday, Mr. Bernanke suggested that the Fed was inclined to sit back and let the long series of previous rate increases — to 5.25 percent from 1 percent in June 2004 — work their way through the economy.

In response to a question from Senator Paul S. Sarbanes, Democrat of Maryland, Mr. Bernanke said the economy was “in a more normal range of interest rates at this point.’’

“I do think it’s beginning to have some effect,’’ he said. “We are trying to judge the effect on both real output and inflation and trying to make our best judgment.”

Mr. Bernanke, though emphasizing the need for vigilance, showed little alarm. “We can’t do anything about this month’s inflation number, because our policy works with a lag,” he told lawmakers.

He then pointed to a range of indicators that showed the economy was slowing, a trend that Fed officials hope will ease inflation pressures. He called particular attention to evidence of a slowdown in the housing market, where home sales have fallen and new construction has dropped. The slowdown “appears to be more broad-based” than could be explained by seasonal factors or the vicissitudes of weather, Mr. Bernanke said.

Consumer spending is likely to be “restrained” by the decline in home equity withdrawals and a slowdown in real estate prices. And while wages are likely to climb and the labor market in many industries appears “tight,” Mr. Bernanke was optimistic that higher wage costs would be largely offset by continued strong growth in productivity.

In general, the Fed chairman appeared cautiously confident that economic growth would remain strong enough to prevent a big jump in unemployment without aggravating inflationary pressures.

He pointed to strong increases in business investment, rising backlogs in orders for big equipment, strong corporate profits and signs of solid growth in the global economy.

“Over all, the U.S. economy seems poised to grow in coming quarters at a pace roughly in line with the expansion of underlying productive capacity,” Mr. Bernanke said.

But lawmakers, Republicans and Democrats alike, made it clear that they were already worried about the pain of higher interest rates. “You don’t want the medicine to destroy the patient, right?” asked Senator Richard C. Shelby, Republican of Alabama.

Some Democrats, meanwhile, warned that the economy was already in trouble.

“The economy is slowing down, and the run-up in oil prices is contributing to that slowdown,” Mr. Sarbanes of Maryland said. “Not only are jobs growing slowly, but all the measures of wages and compensation show gains below inflation over the last year.”

Mr. Bernanke acknowledged that wage gains had been modest and that corporate profits remained unusually high as a share of the total economy. But he expressed hope that corporations would use some of those profit margins to meet demands for higher wages from workers without raising prices to customers.

“I do think the wages will rise,” Mr. Bernanke said. “I’m a little surprised they haven’t risen more already.”
 
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