bernanke puts reputation on line

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Bernanke Puts Reputation on Line, Emphasizes Inflation Outlook
Aug. 9 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke put his inflation-fighting credibility on the line after barely six months in the job, leaving interest rates unchanged even as inflation quickens.

Bernanke led a majority vote yesterday to keep the benchmark lending rate at 5.25 percent, and the statement emphasized the outlook for prices rather than the recent pickup in inflation. In the process, he lost unanimity among policy makers as Richmond Fed President Jeffrey Lacker voted against the decision, preferring an 18th-consecutive increase.

The Fed said prices will ``moderate over time'' as the cumulative effect of prior rate increases, surging energy prices and a sagging housing market slow growth. Fed watchers said the strategy is risky because there's no sign inflation is abating, and failure may erode the credibility built up under former chairmen Alan Greenspan and Paul Volcker.

``The Fed is going out on a limb,'' said John Silvia, chief economist at Wachovia Corp. in Charlotte, North Carolina. ``Bernanke has given us a story: moderating economic growth will lead to moderating inflation. That is going to be the test of his credibility.''

Between now and the Sept. 20 policy meeting, the government will release at least three inflation reports, as well as data on housing, retail sales and job growth. If the indicators show inflation isn't moderating, economists said the decision likely marks a pause, not a peak, in the rate cycle.

Tightening Ahead

An increase yesterday may have made it easier for Bernanke to sell a pause because it would have damped speculation he's softer on inflation than his predecessors, some Fed watchers said. Three-quarters of the 101 economists surveyed by Bloomberg News predicted no change this month.

``It's very likely they're going to be forced into a few more interest-rate increases during the fall,'' said Stephen Cecchetti, an economics professor at Brandeis University in Waltham, Massachusetts and former New York Fed research director.

Still, futures traders took their cue from the statement and pared bets that the central bank will boost rates again. December contracts traded on the Chicago Board of Trade showed about a 53 percent probability the benchmark rate will finish the year at 5.5 percent.

``If I'm sitting at the Fed, I have a tough choice here,'' said Ethan Harris, chief U.S. economist at Lehman Brothers Holdings Inc. in New York. ``Which war am I going to fight: is it the growth slowdown or the inflation pickup? To me the inflation story looks a lot more serious at this stage.''

Harris, a former head of domestic economic research at the New York Fed, predicts two further quarter-point rate increases this year.

Bernanke Tries Again

The statement yesterday is Bernanke's third attempt to get markets to buy into his outlook.

Appearing before the Congress on April 27, he said the Fed could pause even if the risks to inflation were ``not entirely balanced.'' Market indicators of inflation expectations rose, investors questioned his commitment to stable prices, and Bernanke had to counter with a strong anti-inflation speech June 5. In another turn before Congress July 19, he again telegraphed a pause, citing the delayed effects of monetary policy changes.

Barclays Capital Inc. told clients to buy Treasury notes indexed to inflation to protect their returns. The firm expects the benchmark lending rate to rise to 5.75 percent by December.

``Inflation pressures will continue to rise,'' said Michael Pond, Barclays's interest-rate strategist in New York. ``There is certainly the risk that the Fed could be increasingly seen as behind the curve.''

Role of Housing

Economists views on the depth of the slowdown hinge on their estimates about home sales and mortgage refinance, which drove consumer spending when interest rates were low.

``The property market is slowing very meaningfully, and I think it would be a mistake to keep chasing inflation,'' said Paul McCulley, managing director at Pacific Investment Management Co. in Newport Beach, California. He said the Fed's two-year rate campaign is ``done'' and expects the central bank to cut rates in the first half of 2007.

Gross domestic product slowed to an annual rate of 2.5 percent last quarter, down from 5.6 percent in the prior three months. Fed officials anticipate growth in the second half will stay around the second-quarter rate, according to their forecasts presented to Congress in July.

The Commerce Department's estimates will be revised twice more, and economists expect the revisions to push up the second- quarter pace. That would mean the slope of the Fed's predicted downturn would have to be even steeper.

Reliability of Forecasts

``I used to make jokes about how bad Fed forecasts are when I was there,'' said William Ford, former Atlanta Fed president and now a professor at Middle Tennessee State University in Murfreesboro. ``The Fed is no better than most private economists, worse than some. I don't think you can put that much weight on forward-looking inflation expectations as opposed to actual inflation.''

Inflation quickened to 2.4 percent in the 12 months that ended in June, according to the Commerce Department's personal consumption expenditures price index, minus food and energy. Prices haven't increased faster than that since April 1995.

Labor costs rose 3.2 percent in the past 12 months, the most since the fourth quarter of 2004, the Labor Department said yesterday.

``They're going to have to see if the slowdown is going to persist,'' said former San Francisco Fed President Robert Parry. ``They're probably going to reach a conclusion that their job is not done.''



To contact the reporters on this story:
Craig Torres in Washington at [email protected];
Steve Matthews at [email protected]

Last Updated: August 9, 2006 00:02 EDT