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Bernanke Stays within Narrow Range of October 31 FOMC Policy Statement

Bernanke Stays within Narrow Range of October 31 FOMC Policy Statement

Chairman Bernanke??™s testimony before the Joint Economic Committee was a repetition of the essence of the October 31 FOMC statement, with an update about recent developments. A large part of the testimony was devoted to the history of the crisis and the different measures put in place to help ???distressed subprime borrowers.???

He indicated that the third quarter GDP report did not contain evidence of spillover effects from the housing market debacle. He also mentioned that going forward the FOMC does not expect the strength of the second and third quarter to be sustainable. Real GDP was predicted to slow considerably in the fourth quarter and remain ???sluggish??? in the first part of 2008. An improvement in the credit market and winding down of the housing market correction were seen as factors accounting for a revival in economic growth in the second-half of 2008. This is the most likely and rosy scenario of the FOMC. Against the background of the recent Fed rhetoric downplaying the probability of a lower federal funds rate, this statement suggests that a weak headline GDP for fourth quarter that exceeds the Fed??™s forecast will be necessary to bring about a lower federal funds rate, holding other things constant. That said, ???other things constant??? could change (example: financial market disruptions) and present a case for a lower federal funds rate even if GDP was close to expectations. By the same token, a run on the dollar could prevent a lower federal funds rate also.

Bernanke reiterated that downside risks to growth and the upside risks to inflation are seen as evenly balanced. The FOMC sees downside risk of economic growth resulting from deteriorating financial market conditions. In addition, the possibility of lower prices of homes translating into a reduction in consumer spending and an increase in ???investors??™ concerns about mortgage credit??? were cited as other issues that could destabilize economic growth.

On the inflation front, Bernanke pointed out that core inflation had improved during the year but the outlook was ???subject to important upside risks.??? Higher prices for crude oil and some commodities and the sinking value of the dollar were cited as the culprits. He was also of the opinion that ???if inflation expectations became unmoored??? it would have the potential to boost inflation in the longer run. Speaking about inflation expectations, the spread between the nominal 10-year U.S. Treasury note yield and the 10-year inflation indexed Treasury security (see chart 1) has moved up from a low of 219 basis points in early-September, 2007 to 243 basis points as of November 7, 2007.

He had in mind the October employment report in his comments about the resilience of the economy seen in economic reports after the October 30-31 meeting. In contrast to this bullish view, he noted that the financial market news points to continued market stress and the upward trend of crude oil prices implies renewed pressures on inflation. Putting these thoughts in perspective, he concluded that the ???FOMC will continue to carefully assess the implications for the outlook of the incoming economic data and financial market developments and will act as needed to foster price stability and sustainable economic growth.???