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Testimony of Chairman Ben Bernanke Semiannual Monetary Policy Report to Congress

Thu, Jul 19 2007, 07:26 GMT
by Rae Anne Dodds

BBVA Bancomer

• Fed’s forecast for 2007 and 2007 GDP growth is revised downward
• Core inflation still “predominant policy concern”
• The testimony is consistent with the federal funds target remaining at 5.25%

Despite GDP downward revision, the Fed is still positive about future growth

Bernanke noted that “after having run at an above-trend rate earlier in the current economic recovery, U.S. economic growth has proceeded during the past year at a pace more consistent with sustainable expansion.” This “sustainable expansion” was supported in the downward revised GDP forecasts. Real GDP growth in 4Q07 is now forecasted at 2.25%-2.50%, versus the February forecast of 2.50%- 3.00%. Nominal GDP growth in 4Q07 also saw a -0.50% revision (central tendency). Despite expected pick up in GDP growth in 2008 (versus 2007), the Fed now expects 2008 unemployment to be “about 4.75%” compared to 4.5%-4.75%. Nonetheless, Bernanke found this difference to be minimal.

The downward GDP adjustment “to a considerable degree…reflects the ongoing adjustment in the housing sector.” While Bernanke acknowledged the 2H06 “tentative stabilization” in housing demand, he focused more upon supply concerns by highlighting the rising inventories to new home sale ratio. This excess housing supply supported Bernanke’s assertion that the “declines in residential construction will likely continue to weigh on economic growth over coming quarters, although the magnitude of the drag on growth should diminish over time.” The anticipated diminishing drag stems from the expected employment expansion, low mortgage rates relative to historical norms, and real compensation rising over the past year.

Areas identified as stimulating GDP growth were consumption spending “aided by a strong labor market”, the external sector and business fixed investment “bolstered by gains in sales and generally favorable financial conditions.” Balancing the varying forces upon GDP growth, caused Bernanke to expect the economy “to expand at a moderate pace over the second half of 2007, with growth then strengthening a bit in 2008 to a rate close to the economy’s underlying trend.” The 2008 growth increase stems from anticipated shrinking downward forces. Upside risk to the forecast stemmed from the potential of consumer spending expanding more than expected, while downside risk remains in the housing sector. Specifically, if the housing correction “prove[s] larger than anticipated, with possible spillovers onto consumer spending.”

Given our productivity expectations and the previous FOMC minutes, it was not surprising for Bernanke to reveal his anticipation of productivity rising in the future (which is contrary to the Fed staff’s belief). He recognized the recent decline by stating that the “combination of moderate gains in output and solid advances in employment implies that recent increases in labor productivity have been modest by the standards of the past decade,” yet he continues to assert that “the cooling of productivity growth in recent quarters is likely the result of cyclical or other temporary factors.” Bernanke does concede that “the underlying pace of productivity gains may also have slowed somewhat,” but comments later in his speech clearly indicate that he clearly anticipates productivity to increase.1 This adds further support to the Fed’s outlook of higher GDP growth in 2008, compared to 2007.

Core inflation still trumps headline inflation

The Fed maintained its core PCE inflation forecast of 2.00%-2.25% for 2007 and eventual decline into the comfort zone at 1.75%-2% in 2008. Although his confidence in the anticipated deceleration relied on “contained” inflation expectations, flattening in energy and commodity futures prices, and expected easing in the labor market (slightly higher unemployment in 2008), the upside risks to inflation were just as numerous. The “elevated” level of resource utilization continues to be the principal upside risk. Energy and commodity prices pose other upside risks both from the immediate influence in headline inflation and possible pass-through to core measures, while the potential of higher current inflation rates becoming “embedded in longer-term inflation expectations” was also discussed.

“Sizable increases in food and energy prices” elevating overall inflation and eroding real incomes were identified as “unwelcome developments.” Bernanke conceded that the headline PCE inflation annual rate of 4.4% in the first five months of this year is “inconsistent with the objective of price stability,” but he anticipates “overall inflation [to] slow to a pace close to that of core inflation in coming quarters” as “energy prices level off.” In the end, Bernanke returns to discussing the importance of core inflation as a “better gauge than overall inflation of underlying inflation trends,” thus he acknowledged the recent anguish caused by high headline inflation but continues to base his forward-looking policy decisions upon the core measurement.

Monetary policy pause will continue

Despite the fact that the lower GDP forecasts could suggest a dovish attitude; Bernanke was explicit in identifying inflation as its “predominant concern.” Even with the persistence of a FOMC hawkish nature, the testimony gave evidence of a further pause in monetary policy. Bernanke stated the “existing stance of policy was likely to be consistent with growth running near trend and inflation staying on a moderating path.” Given the Fed forecast of 2008 growth “close to the economy’s underlying trend” and the inflation being within the FOMC’s comfort zone, we maintain our base scenario of an extended pause at 5.25% during 2007 and into 2008.

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Published on  Thu, Jul 19 2007, 07:30 GMT