BB: U.S. risks downturn, inflation

U.S. faces risks of downturn, inflation: Bernanke

By Greg Robb, MarketWatch | 8 November 2007

WASHINGTON (MarketWatch)—

The U.S. economy not only faces the risk of a sharp slowdown from the housing market's contraction but also of an inflationary surge from sharply higher crude-oil prices and the weaker dollar, Federal Reserve Chairman Ben Bernanke said Thursday. In prepared testimony to the Joint Economic Committee of Congress, Bernanke painted a picture of an economy in a perilous position, even though it has shown remarkable resilience so far this year, with third-quarter gross domestic product rising at a solid 3.9% annual pace. Higher oil prices have 'renewed upward pressure on inflation and may impose further restraint on economic activity.' Bernanke said that he and his colleagues on the policy-setting Federal Open Market Committee expect the economy to slow "noticeably" from the third-quarter growth rate and remain sluggish in the first half of 2008. But Bernanke also suggested that the hawkish members of the Fed might have a point about inflation. There were downside risks to the subdued growth forecast, and upside risks to the benign inflation outlook, Bernanke said.

The FOMC also believes that overall and core inflation will be "in a range consistent with price stability" in 2008, Bernanke said.

He noted that prices for crude oil and other commodities have risen sharply in recent weeks and that the dollar has weakened in foreign-exchange markets.

"These factors were likely to increase overall inflation in the short run and, should inflation expectations become unmoored, had the potential to boost inflation in the longer run as well," Bernanke said.

The run-up in crude prices since the FOMC meeting on Oct. 31 has "renewed upward pressure on inflation and may impose further restraint on economic activity," Bernanke said.

Bernanke bluntly said that headline inflation is going to rise in the short term.

Reading the tea leaves on rates

Sen. Charles Schumer, chairman of the economic panel, said he was concerned about a big downturn on the horizon.

"Quite frankly, I think we are at a moment of economic crisis stemming from four key areas: falling housing prices, lack of confidence in creditworthiness, the weak dollar and high oil prices," said Schumer, D-N.Y. "Each of these problems alone would be enough of a threat to our economic well-being. But taken together, they are essentially the four horsemen of economic crisis."

The FOMC cut benchmark interest rates by a quarter of a percentage point on Oct. 31 and moved to a "neutral" stance by saying that the risks of a downturn and higher inflation were roughly in balance.

Analysts said this could be taken as a sign that the Fed wants to hold rates steady at least through the end of the year, but they conceded that developments could overtake such a scenario.

Allen Sinai, chief economist for Decision Economics in New York, said Bernanke's remarks underscore this desire to hold rates steady until at least the Jan. 30 FOMC meeting.

"We see nothing here to alter our view that after pausing at the next meeting on December 11, the FOMC will respond to a weakening economy with a 25bp rate cut in late January and another in the early spring," agreed Josh Shapiro, chief U.S. economist at MFR Inc.

But other economists said Bernanke was still being too rosy about the outlook.

"Until the Fed gets real and stops referring to the housing disaster as a mere 'correction' they will be behind the curve. The data will force them to ease more, likely on Dec 11," said Ian Shepherdson, chief U.S. economist at High Frequency Economics.

Regarding the outlook for rates policy, Bernanke said only that the FOMC would continue to assess the economic data and financial market developments "and will act as needed to foster price stability and sustainable economic growth." He added that the central bankers were not being "dogmatic," but would respond as needed depending on the information on the outlook that emerges in coming weeks.

Bernanke also told the committee that the few data releases since the Oct. 31 FOMC meeting "suggest that the overall economy remained resilient in recent months." At the same time, financial markets' volatility and strains have persisted. He said the FOMC's view that the economy would slow sharply in the fourth quarter was due to many factors, including the likelihood of a weakening in consumer and business spending.

Bernanke pushed back the date that the housing market would hit bottom until June of 2008.

"At the risk of being proved wrong again...our current calculation is that things will begin to flatten out in the second quarter of next year," Bernanke said, quickly adding that this forecast was "very provisional." The U.S. consumer, who's been an economic bulwark of late in the eyes of many observers, might not be able to withstand the combined effects of higher energy prices, tighter credit and continuing weakness in housing.

Prospects for housing remain poor

Indeed, the short-term outlook for the housing market continues to appear grim, Bernanke said. The turmoil in financial markets means that the fractured mortgage market will not be able to recover, with delinquencies on subprime mortgages likely to rise further in coming quarters. Even the most risk-free mortgages are only being made with higher spreads and restrictive terms, Bernanke said.

Bernanke said the Fed did not have an "alarmist" view on a prospective drop in home prices across the country. Spending might slow, but not fall off the table, he said.

On possible regulation of the mortgage market, Bernanke told lawmakers that the Fed is on track to propose rules about unfair or deceptive mortgage-lending practices by the end of this year. The rules would apply to subprime loans, extended to borrowers with poor credit records.

Interest rates on those loans are expected to shoot up as they "reset" between now and the end of 2008, leaving many borrowers strapped for cash and resulting in some foreclosures.

Bernanke urged lawmakers to consider reforming federal housing programs to speed up the refinancing of subprime loans and to allow the government to design new loan products aimed at at-risk borrowers.

Echoing a view shared by many, he said a sharp increase in foreclosures could weaken the housing market, "and thus, potentially, the broader economy." In question and answer session, Bernanke refused to place any odds on the likelihood of a recession.

He said the Fed does see growth remaining positive, albeit slow.

Bernanke brushed aside the concern that hit financial markets after a mid-level Chinese official suggested on Monday that China would shift out of its massive dollar holdings.

Bernanke noted that countries that peg their currencies to the dollar have to hold dollars. He said he was not aware of any change in the dollar holdings of any major country.

Bernanke later repeated the mantra of U.S. economic officials that China should loosen, if not eliminate, its peg to the dollar.

Bernanke agreed with a Republican lawmaker than any net increases in taxes would probably not be a good idea at the moment.

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