Bernanke's JEC Testimony

On Wednesday, May 22, Federal Reserve Chairman Ben Bernanke will testify on “The Economic Outlook.” The next monetary policy meeting is four weeks away, but Bernanke is likely to provide a preview of what will be discussed at that time – specifically, on the issue of when to begin reducing the rate of asset purchases. The short answer may be “it depends.”

Recent data reports suggest a mixed bag in the current quarter. Retail sales were not as bad as feared in April, but were far from what one would consider to be “strong.” Manufacturing data has been relatively soft. The labor market remains a key focus for Fed policymakers, and is an important indicator of the amount of slack in the economy. While the unemployment rate has trended lower over the last few years, a lot of that decline has been due to a drop in labor force participation (with about a quarter of that due to demographics). The employment/population ratio has continued to trend at a low level. Long-term unemployment remains elevated.

Inflation has been trending lower. Some of that reflects the decline in gasoline prices (which has been amplified more recently by the seasonal adjustment, which looks for large seasonal increases in the spring). However, core inflation is also trending down. Commodity prices are soft, reflecting weakness in the global economy. Prices of imported raw materials and finished goods show no inflation pressure. Capacity utilization in manufacturing remains low, suggesting no inflation pressure for production constraints. The slack in the labor market will limit wage pressures. Inflation expectations remain well anchored. In the last few years, many market participants have feared that fiscal and monetary policies would lead to sharply higher inflation. We’ve maintained that such a surge would be very unlikely given the amount of slack in the economy. In their projections of late April, Federal Reserve officials expect inflation (as measured by the PCE Price Index) to trend at or below the 2% target both this year and next.

Recall that the Fed is undertaking two extraordinary policies: the forward guidance on the overnight lending rate (the conditional commitment to keep short-term interest rates exceptionally low) and the Large-Scale Asset Purchase program (what most people call “QE3”). The Fed has quantitative thresholds on the forward guidance (unemployment above 6.5%, an inflation outlook of not more than 2.5%, stable inflation expectations), but these are guideposts, not targets. Importantly, the Fed has indicated that it will keep short-term interest rates low for some time after the recovery picks up steam. The LSAP has a qualitative threshold (“substantial improvement” in the labor market), which makes it a judgment call. Nobody at the Fed is happy that they are purchasing assets, but the majority feels that it’s the right thing to do. The Fed has spent a lot of effort working out its exit strategies, which include an eventual reduction in the rate of asset purchases, but that doesn’t mean that we’ll see a change anytime soon. Clearly, a lot will depend on the job market data.

In the April policy statement, the FOMC indicated that the pace of asset purchases could be raised or lowered depending on how the economic outlook evolved. That seemed to soften concerns that asset purchases would end sooner rather than later. However, even with the mixed economic data of the last few weeks, the debate has shifted back to when to end QE3. Why was the possibility of increasing the pace of asset purchases included in the April policy statement? One concern is that inflation could prove to be too low. It’s real (inflation-adjusted) interest rates that matter for the economy. So lower inflation would, all else equal, imply higher real rates. The majority is clearly far away from raising the pace of asset purchases, but the issue was likely on the table at the April FOMC meeting. Let’s see if Bernanke brings it up this week.

© Raymond James

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