Fed Chairman Provides Testimony and the Semiannual Monetary Policy Report to Congress

• The U.S. economy is now cooling to a more sustainable rate of expansion.
• There has been a substantial correction of the housing market, but no significant spillover effects.
• Nevertheless, weakness in residential investment will likely continue to weigh on economic growth over the next few quarters.
• Consumer demand continues move ahead at solid rates, and the demand for labor is still strong.
• Inflation pressures have abated, but core inflation is still somewhat elevated and upside inflation risks remain the dominant policy concern.
• FOMC expects core PCE inflation to ease to a range of 2.00–2.25% at the end of 2007 and 1.75–2.00% at the end of 2008.
• The Federal Reserve projects that real GDP growth will slow down from just over 3.0% (per an expected late-February revision) at the end of 2006 to 2.5–3.0% in 2007 and 2.75–3.00% in 2008.
• Monetary policy affects spending and inflation with long and variable lags, and policy decisions must therefore be based on medium-term prospects.
• The broad range of incoming information leads to frequent reassessments of the outlook, and that complicates the public's attempts to anticipate policy decisions.
• The FOMC established a subcommittee to examine steps to improve communication, but no decisions have been reached.

Analysis

Federal Reserve Board chairman Ben Bernanke provided a highly skillful and noncontroversial monetary report to Congress, indicating that the U.S. economy has slowed down to a more sustainable rate and that inflation is showing preliminary signs of abating. The maintenance of steady interest rates for the past five policy meetings of the Federal Open Market Committee (FOMC), according to the chairman, is consistent with a stance for monetary policy that will foster sustainable growth and further easing in core inflation.

The Fed's updated outlook for growth and inflation in 2007 and 2008 is pretty much in line with Global Insight's latest January 2007 forecast. The Federal Reserve, however, has reduced its forecast for 2007 GDP growth by about 0.4 percentage point compared with the July 2006 forecast, due to greater weakness in residential construction. The Fed's projected range for core inflation at the end of 2007, 2.00–2.25%, is little higher than Global Insight's projection of 1.9%. While the Fed does not disclose its policy assumptions undergirding its inflation forecast, we can nevertheless take some comfort that the Fed is not taking a dogmatic approach to its "1–2% comfort zone" on core inflation. Inflation running just above this range, while not optimal from the Fed's perspective, would not necessarily provoke further moves to tighten policy, so long as growth and resource utilization remains moderate and within reasonable bounds of potential. The Fed expects core inflation to moderate further in 2008.

Bernanke stated that the risks to the outlook are significant, but appear to be balanced. On the downside, "the ultimate extent of the housing market correction is difficult to forecast and may prove greater than we anticipate." On the upside, growth may accelerate if consumer spending continues to expand at the brisk rates that we saw at the end of 2006. January's retail sales report, where core retail sales advanced by a very modest 0.2%, suggests that upside risks are not particularly salient at this juncture—they certainly should not keep the FOMC awake at night for the time being.

The chairman concluded his remarks with some discussion on the execution of monetary policy and the Fed's recent efforts to improve communication. Since monetary policy affects spending and inflation with long and variable lags, policy decisions must be based on the Fed's assessment of medium-term economic prospects. However, these assessments are constantly being refined, based on incoming information, and this complicates the public's attempts to understand and anticipate policy decisions. As it stands now, the Federal Reserve provides an update of its assessment of medium-term economic prospects only twice a year, in the Semiannual Monetary Policy Report. In order to improve the communications process, the Fed established a subcommittee directed at examining all aspects of its communications. However, Bernanke stated that the discussions are continuing, and no decisions have been reached.

by Brian Bethune