Federal Reserve Concerned about the Economy

Federal Reserve officials have dialed up their concerns about the potential for runaway prices and about the downside risks to growth, Fed Chairman Ben Bernanke said Tuesday.

In his seminannual testimony to the Senate Banking Committee, Bernanke reserved his clearest warning for inflation. The Fed must remain 'particularly alert' to any sign that inflation is getting out of control, Bernanke said.

Video: Bernanke speaks

Federal Reserve Chairman Ben Bernanke addresses the U.S. Senate Banking Committee. Video courtesy of Fox News. (July 15)But he also spoke candidly about the weak economy and fragile financial markets. 'The possibility of higher energy prices, tighter credit conditions, and a still-deeper contraction in housing markets all represent significant downside risks to the outlook for growth,' Bernanke said.

According to a report to Congress submitted along with Bernanke's testimony, the Fed said that FOMC members were more uncomfortable about the inflation outlook at their June meeting than they had been at any point this year.
The Fed sees slow growth for the second half of the year and into next year. And risks remain that the economy will be weaker than the forecast.

Financial markets scaled back expectations for rate hikes later this year. 'We are not facing imminent rate hikes,' said Lou Crandall, chief economist at Wrightson ICAP.
Monetary policy at a standstill for now?
Josh Shapiro, chief U.S. economist at MFR Inc, said Bernanke signaled interest rates could be steady for a while.

'All in all, this testimony indicates frozen monetary policy, with enormous downside economic and financial risks offsetting any impetus to tighten in the face of higher headline inflation. This is consistent with our view that the Fed funds target will remain at 2% at least through mid-2009,' he said.

Stocks fell after Bernanke began his testimony. The dollar slumped and Treasury prices rose. By afternoon, stocks had turned higher as oil prices slumped. See full story.
One economist said it wasn't Bernanke's worries about growth that drove markets, but the lack of any road forward.

'The Fed does not act like it has a plan to get us out of this. That's what markets did not like to hear,' said Robert Brusca, chief economist at FAO Economics.
On the one hand, the Fed is worried that high oil prices, combined with the weak dollar, will increase business costs, pushing prices higher. This could force workers to demand higher compensation because of the more expensive cost of living.

As a result, most Fed members believed inflation could come in higher than expected in coming months.
'In light of the increase in upside inflation risks, we must be particularly alert to any indications, such as an erosion of longer-term inflation expectations, that the inflationary impulse from commodity prices are becoming embedded in the domestic wage- and price-setting process,' Bernanke said.

On the other hand, higher gas prices, tighter credit conditions and a housing recession could push the economy lower, Bernanke said.

Inflation worries would persist even if commodity prices slowed their steady march higher, Bernanke said.
'The currently high level of inflation, if sustained, might lead the public to revise up its expectation for long-term inflation,' Bernanke said.

This could set off a chain of events that would cement 'an unwelcome rise in actual inflation over the longer term,' Bernanke said.

Higher inflation, below-trend growth this year
No matter what, inflation 'seems likely to move temporarily higher in the near term,' Bernanke said.
In its latest forecast, Fed officials actually increased their projection for economic growth in 2008, given the stronger-than-expected consumer and business spending data that was released in May and June.
The economy, as measured by gross domestic product, was projected to grow at a 1.0-1.6% annual rate this year. This is up from the previous forecast in April of growth in a range of 0.3-1.2%.

But growth in the second half of the year would be well-below trend, Bernanke said, due to continued weakening in housing markets, elevated energy prices and tight credit conditions.

But fears have eased somewhat of a vicious downward spiral, where weak financial conditions push down growth, which leads to weaker financial conditions.

Bernanke stressed that he did not believe the U.S. financial system was insolvent. He pressed banks to continue to lend money to clients.

'Our banking system is well capitalized. My concerns have turned less on the solvency of these institutions and more on their ability to extend the credit that our economy needs to keep growing - because in many cases banks are deleveraging or shrinking or reluctant to take advantage of business opportunities,' Bernanke said.

Bernanke defended the government plan announced Sunday to authorize the Fed to lend to Fannie Mae and Freddie Mac in an emergency. Treasury Secretary Henry Paulson and Securities and Exchange Commission Chairman Christopher Cox also briefed senators on the plan. See full story.