Bernanke Signals Deeper Rate Cuts, Emphasizes Growth

Date: Monday, January 14, 2008
Author: Craig Torres, Bloomberg.com

Federal Reserve Chairman Ben S. Bernanke signaled he has resolved months of debate over the competing risks of slower growth and faster inflation, and is ready to make deeper interest-rate cuts.

Bernanke yesterday pledged ``substantive additional action'' to insure against ``downside risks'' to the six-year economic expansion. His remarks in a Washington speech led HSBC Securities USA Inc. and Morgan Stanley to predict the Fed will reduce its benchmark rate by half a percentage point this month, up from their previous forecast of a quarter point.

The central bank faces the most challenging moment of Bernanke's two years in office as both of the Fed's goals are under siege: unemployment is at a two-year high, while prices are also climbing. Until now, the deliberations produced non- committal statements from the Fed, which used ``uncertainty'' to describe the outlook in December.

``They have to save the economy and let inflation go,'' said Allen Sinai, chief economist at Decision Economics Inc. in New York. ``We are in a recession-like situation right now.''

The shift may have been driven by the Labor Department's Jan. 4 report showing the jobless rate jumped to 5 percent in December, economists said. The figures also showed a decline in private-sector employment.

`More Pronounced'

The speech by Bernanke, 54, was unusual because he made few references to the ``committee,'' as he frequently does when discussing options before the Federal Open Market Committee. He said the forecast for 2008 ``has worsened'' and risks to growth are ``more pronounced,'' effectively rewriting the FOMC statement of Dec. 11.

Two-year Treasury yields fell to the lowest in three years on speculation of further interest-rate cuts. The yield on the two-year note fell 5 basis points to 2.65 percent by 12:00 p.m. in London, according to bond broker Cantor Fitzgerald LP.

``Bernanke chose to finally assume the mantle of leadership,'' said Michael Feroli, an economist at JPMorgan Chase & Co. in New York. ``He has generally sought to avoid front-running the committee.''

Brian Sack, a senior economist at Macroeconomic Advisers LLC in Washington who used to work at the Fed, said the shift in Bernanke's language indicated he and his colleagues may have conferred after the Jan. 4 job figures.

Aggressive Shift

``The fact that the policy message seemed to be shifted so aggressively suggests there was some committee-wide communication in recent days.'' Sack said.

The 14-page speech contained one paragraph on inflation. The Fed's preferred price measure, the personal consumption expenditures price index minus food and energy, rose at a 2.6 percent annualized rate for the three months ending November.

``We will see more worrying signs'' of inflation, Martin Feldstein, the Harvard University economist who is head of the National Bureau of Economic Research, told Bloomberg Television in an interview. ``It is a serious problem, but yet it isn't the primary problem, which is the weakness of the economy.''

The FOMC has cut the benchmark rate 1 percentage point to 4.25 percent since September to offset the drag from tighter lending conditions and the prolonged housing slump.

In contrast, the European Central Bank has left its key rate at 4 percent and President Jean-Claude Trichet yesterday signaled it may raise borrowing costs to contain inflation even as economic growth slows. The ECB's Governing Council is ``prepared to act preemptively'' to prevent risks to price stability from materializing, Trichet said in Frankfurt.

Recession Forecast

Lehman Brothers Holdings Inc. added another half-point of interest-rate cuts to its forecast through August, saying today that the Fed will lower its rate to 3 percent, including a half- point this month instead of a quarter-point. Goldman Sachs Group Inc. economists predicted this week that the Fed will lower its rate to 2.5 percent by year-end. The bank also joined Merrill Lynch & Co. and Morgan Stanley in projecting a recession.

The weakening economy ``just makes it more difficult to maintain an active rhetorical or any other focus on inflation,'' said Edward McKelvey, senior U.S. economist at Goldman in New York.

Residential investment has declined for seven consecutive quarters, and Fed officials say it may take at least six more months before housing markets rebound. Delinquency rates on subprime mortgages climbed to 16.3 percent in the third quarter, the highest in at least a decade.

``The demand for housing seems to have weakened further, in part reflecting ongoing problems in mortgage markets,'' Bernanke said.

Unemployment Rises

Payrolls rose by 18,000 last month, with the first decline in private jobs since 2003. The unemployment rate rose to 5 percent, from 4.7 percent the previous month.

The more aggressive response signaled by Bernanke today may come too late to prevent a sharp slowdown, said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey. ``If we have a recession coming, then all this does is create a more conducive environment for the economy's convalescence.''

``Should the labor market deteriorate, the risks to consumer spending would rise,'' Bernanke said in his prepared remarks to the Women in Housing and Finance and Exchequer Club.

``This tells you the chairman's mindset has moved,'' said Credit Suisse Group Chief Economist Neal Soss, who changed his forecast yesterday to a half-point rate cut this month. ``He acknowledges inflation risk -- it's his job to do so -- but certainly that's not the primary focus.''

Inflation expectations measured by yield differences on 10- year Treasuries and government inflation-indexed bonds have remained between 2.2 percent and 2.4 percent over the past year, a sign that investors have confidence the central bank will maintain price stability in the long-term.

``Any tendency of inflation expectations to become unmoored or for the Fed's inflation-fighting credibility to be eroded could greatly complicate the task of sustaining price stability and reduce the central bank's policy flexibility to counter shortfalls in growth in the future,'' Bernanke said.

To contact the reporter on this story: Craig Torres in Washington at ctorres3@bloomberg.net