Bernanke’s Dilemma

Ben Bernanke’s dilemma deepens by the day. The Federal Reserve chairman suggested Wednesday the central bank should be cautious in raising interest rates further. Hours earlier the government released troubling inflation figures that leave Mr Bernanke little choice but to push rates even higher.

The US economy is caught between slowing growth and rising inflation, a central banker’s nightmare. There is little question prices are trending higher: the consumer price index, minus food and energy, rose 2.6% year on year in June, the third straight month prices accelerated and the worst showing in more than five years. That’s normally a prescription for higher interest rates. Yet Mr Bernanke, speaking to lawmakers, acknowledged that economic growth is slowing. That’s usually a reason to cut rates. So, which is it?

Mr Bernanke, unsurprisingly, hedged his bet. Presenting his semi-annual policy report to Congress, he said the Fed must consider the lagged effects of previous rate hikes—those that are “still in the pipeline.” That suggests the Fed may be ready to pause after raising rates 17 straight times. Markets promptly soared, with the Standard & Poor’s 500 equity index rising by almost 2%. US Treasury bonds also surged as traders assumed the Fed was nearly finished raising rates.

But Mr Bernanke was careful to qualify his remarks. While predicting slower inflation in coming quarters, he admitted the Fed’s past forecasts had been wrong and pointed to the risks of further price gains, mainly from energy. Persistently higher inflation “would be costly to reverse,” he cautioned, and the Fed must guard against “the emergence of an inflationary psychology.”

Credibility and Psychology

Credibility, not just psychology, is also at stake. While financial markets interpreted Mr Bernanke’s comments as the prelude to a pause, the Fed risks a damaging loss of credibility if it appears soft on inflation. Mr Bernanke learned that lesson in April when he worried aloud about the risk of over-tightening and then watched as US bond yields soared.

For those reasons, we expect Mr Bernanke to err on the side of raising rates too much, not too little. We are forecasting two more quarter-point rate increases, in August and September, which would bring the federal funds target interest rate to 5.75%, the highest since 2001.

What will this mean for the economy? For consumers, certainly, it means a further slowdown in spending as lenders charge more and the cost of servicing a mountain of household debt rises. Indeed, new Fed figures show debt-service payments as a share of personal income rose to a record 13.9% in the first quarter. Slower gains in house prices will also make balance sheets look stretched and erode purchasing power. So, too, will the recent decline in share prices. Add to this the cost of fuel—the average price for a gallon of petrol was US$3.03 last week, up from US$2.33 a year earlier—and it’s no mystery why consumer spending has been fading, and will fade more. We therefore expect inflation-adjusted GDP to rise by just 2.1% at an annual rate in the fourth quarter, down from 5.6% in the first three months of the year (see chart). Personal spending will fall even more, to less than 2% in the first half of 2007.

Companies are Holding Up

If consumers are starting to suffer, companies are faring better, further complicating Mr Bernanke’s job. Industrial production jumped in June and factory use rose to a six-year high. With busy factories needing workers, the unemployment rate has fallen to just 4.6%, matching a five-year low (see chart).

Companies won’t continue investing and producing at the current rate if consumers genuinely retreat, but for now other factors are keeping businesses going. After investing so little earlier in the decade—following the binge in the late 1990s—companies need to upgrade facilities. That explains why investment in equipment and software has been rising, and jumped by almost 15% in the first quarter. Exports, for a change, are also helping US growth as Europe’s economy emerges from the doldrums and Japan’s recovery looks more sustainable.

This upturn for businesses would be undermined if the Fed raised borrowing costs too much. For now, interest rates adjusted for inflation aren’t excessive by historical measures. The real federal funds rate (the Fed’s target rate minus the change in the core consumer price index) is below where it was for most of the late 1990s, suggesting the Fed can move rates a bit higher without doing real damage to the economy (see chart). Indeed, the current federal funds rate is only just above its 20-year average of around 5%. But the margin for error is narrowing.

Overshooting?

What if the Fed overshoots? That is a risk, especially if core annual inflation remains above the central bank’s comfort zone of 1-2%. We put the chance of a recession next year at about 30%, and the risk would rise if the federal funds rate reaches 6% or higher. But that is not our baseline forecast. We expect the economy to grow by about 2.4% in 2007 (down from 3.3% this year). While consumers will spend less and housing investment will fall, business outlays and trade will grow just enough to keep the economy afloat.

The Fed, though, seems oddly sanguine about the outlook for next year. Although Mr Bernanke says he’s concerned about the lagged effects of so many rate increases, the Fed is forecasting growth of 3-3.25% in 2007, hardly less than its 3.25-3.5% projection for this year. Indeed, while arguing that price rises aren’t a big threat, the Fed is forecasting core inflation of 2.25-2.5% this year and 2-2.25% in 2007—both above its target zone.

Does the Fed have a credibility problem? Perhaps. It certainly has the unenviable task of trying to manage a slowdown in the economy amid rising inflation fears. Alan Greenspan got out just in time.