Ben Bernanke's baptism under fire
By Pete Morici
web posted March 27, 2006
This week, virtually everyone expects the Federal Reserve to raise the benchmark Federal Funds rate to 4.75 percent. What will interest the bond market and economists most will be what clue the Fed offers about future rate hikes.
Wall Street forecasters expect the economy to post a healthy 4.6 percent growth for the first quarter—a welcome bounce from the disappointing 1.6 percent scored in the fourth quarter of 2005.
Core consumer prices—prices for final goods and services less volatile food and energy—have been rising a bit faster than 2 percent annually. That pace appears to be above Ben Bernanke's comfort zone.
Wholesale prices have advancing at more than a 4 annual rate since the beginning of 2006, and gasoline prices have been surging again. In some places premium gas has pierced the $3.00 per gallon threshold.
With numbers like that, it is not surprising most forecasters have built a June Federal Funds rate hike to 5 percent into their predictions. Yet rookie interest rate setter Bernanke faces a challenging policymaking environment.
The housing market has stalled. Median prices for new homes and for resales have been falling since October, and new home sales tanked in February. The pull back in home equities will slow consumer borrowing and spending, throwing water on second half economic growth.
The trade deficit is hitting new records, and while we may love those inexpensive Chinese wares at Wal-Mart and Macy's, imports are a subtraction from GDP. The strong dollar, which makes those imports and low prices possible, will slow the economy in the second half too.
Overall, economic forecasters are betting that growth will slow to about 3.2 percent the second half of this year, and most forecasters expect Bernanke to push the Federal Funds rate to 5 percent at its June meetings.
However, interest rates are a very imprecise tool for regulating economic activity, and pushing the Federal Funds rate to 5 percent or higher could turn a soft landing into a downward spiral that is not easily reversed. An inexperienced Alan Greenspan hit the breaks too hard in 1989, the economy tumbled in 1990, and the Republicans lost the 1992 election.
Growth below three percent would send unemployment heading north again, and at 4.8 percent, unemployment still remains well above its 2000 cyclical low of 3.8 percent. Adult labor force participation remains much lower than it was in 2000, and factoring in those additional discouraged workers, the unemployment rate for comparison to 2000 is above 6 percent.
With the wages of hourly employees, as computed by the Bureau of Labor statistics, lagging inflation for the last three years, none of this can be good news for ordinary folks that do the essential, hard work in America. And for Bernanke, balancing the tradeoff between controlling inflation and exercising some compassion for those frontline workers is a daunting task.
Focusing on inflation, Fed policy can have little impact on gasoline and other energy prices, as these are primarily driven by conditions in international energy markets, refinery capacity constraints and the weather.
Outside the energy sector, most economists are banking on productivity growth to recover and permit businesses to absorb higher energy prices, earn good profits and pay workers modestly better, while keeping the lid on nonenergy consumer prices. Yet, given that economists are more prone to error than the folks that pick the ponies at the track, Bernanke can't bank on anyone's advice and must trust his own instincts.
The Fed Chairman's effectiveness is significantly determined by his credibility with financial markets, and Ben Bernanke is yet to establish his bona fides as an inflation fighter. If the economy slows but inflation is harnessed, Wall Street will bestow laurels on Bernanke but if inflation gets out of control it will make him the goat.
Look for Bernanke to chart a cautious path, err on the side of caution, and raise interest rates to five percent in June and even further by August.
Peter Morici is an economist and professor at the Robert H. Smith School of Business, and serves on the Reuters and Bloomberg macroeconomic forecasting panels.
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