Bernanke Charms Traders a Third Time

Traders read Bernanke's testimony as a dovish confirmation of the June 29 FOMC statement. Bernanke repeated that slowing growth would weaken inflation, and that monetary policy must be based on "the longer-term outlook for both inflation and economic growth."

Regardless of the Fed's blue-sky-no-clouds forecast, Bernanke didn't telegraph a pause in August. Indeed, he devoted much time in his testimony and in the Q&A to inflation -- repeating that inflation is the greatest current threat to the economy. His comments were peppered with hawkish statements, such as: "We have to take into account the risks as well as the expected path ... the chance a bad outcome could occur," adding, "You need to lean a bit against that bad outcome."

Bernanke defensively answered comments about mortgage rates rising and the weak stock market by noting that both markets do much worse in inflationary periods. In the testimony, he said "some inflation risks remain," and they are largely centered around unpredictable prices for energy and other commodities. "If the pattern of elevated readings on inflation is more protracted or more intense than is currently expected, this higher level of inflation could become embedded in the public's inflation expectations and in price-setting behavior."

At best, Bernanke gave himself the flexibility to pause if economic data surprises to the downside, and the credibility to hike again if inflation continues to edge upward. Bernanke said he's "very aware" of concerns about overshooting, but said the situation of addressing higher or more persistent inflation later means "perhaps more interest rate increases. We have to balance those risks in two directions." Bernanke said that at some point the "Fed will have to get off of this 25-basis-point escalator."

Other markets reacted similarly to stocks. Treasury bonds rallied sharply as the 10-year gained 19/32 to yield 5.05%. The dollar sank 0.38% on the news to 116.75 yen from above 117 Tuesday, and the euro gained 0.74% to $1.2602.

Only time will tell if Bernanke and the market's relationship has grown closer. If not, investors will once again be all dressed up with nowhere to go.

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