Bernanke: Some Insights Amid the Expected

Among those were the new Fed chairman's downplaying of the yield-curve inversion.
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Fed Chairman Ben Bernanke delivered testimony that was largely as expected today, but there were still a number of notable facets to the speech.

Here are the aspects that were largely as expected:

Bernanke said that he would seek continuity with the policies of Fed Chairman Alan Greenspan:

As I indicated to the Congress during my confirmation hearing, my intention is to maintain continuity with this and the other practices of the Federal Reserve in the Greenspan era.

Bernanke indicated that he would adhere to the consensus on the FOMC expecting more interest rate hikes:

... the FOMC judged that some further firming of monetary policy may be necessary, an assessment with which I concur.

Bernanke indicated that the rate hikes seen to date have removed substantial stimulus to the economy:

... it is clear that substantial progress has been made in removing monetary policy accommodation.

Bernanke indicated that future rate hike considerations will be increasingly data dependent:

... in coming quarters the FOMC will have to make ongoing, provisional judgments about the risks to both inflation and growth, and monetary policy actions will be increasingly dependent on incoming data.

Unexpected Remarks

Bernanke gave no support to inflation targeting:

Over the past few decades, policymakers have learned that no single economic or financial indicator, or even a small set of such indicators, can provide reliable guidance for the setting of monetary policy. Rather, the Federal Reserve, together with all modern central banks, has found that the successful conduct of monetary policy requires painstaking examination of a broad range of economic and financial data, careful consideration of the implications of those data for the likely path of the economy and inflation, and prudent judgment regarding the effects of alternative courses of policy action on prospects for achieving our macroeconomic objectives.

Bernanke is more worried about the current balance between supply and demand than previously thought:

... the risk exists that, with aggregate demand exhibiting considerable momentum, output could overshoot its sustainable path, leading ultimately -- in the absence of countervailing monetary policy action -- to further upward pressure on inflation.

Bernanke is sanguine about the housing market and expects a benign resolution to the slowing from its recent buoyancy:

... a leveling out or a modest softening of housing activity seems more likely than a sharp contraction ...

Bernanke's inflation view for 2006 is not worrisome but is not as sanguine as expected. He indicated as much by giving a forecast for 2006 that puts the inflation rate at the upper end of the Fed's 2005 target range of 1.75% to 2%:

Inflation, as measured by the price index for personal consumption expenditures excluding food and energy, is predicted to be about 2 percent this year.

Bonus Insights Into Bernanke

There were also additional insightful remarks that tell us more about Bernanke, his views and the indicators he follows:

Bernanke played down the importance of the recent inversion of the yield curve, giving a number of reasons why long rates are low:

Restrained inflation expectations have also been an important reason that long-term interest rates have remained relatively low. ... The premiums that investors demand as compensation for the risk of unforeseen changes in real interest rates and inflation appear to have declined significantly over the past decade or so ... an excess of desired global saving over the quantity of global investment opportunities that pay historically normal returns has forced down the real interest rate prevailing in global capital markets.

Bernanke follows the TIPS market (the market for inflation-indexed securities) as well as surveys on inflation expectations (the University of Michigan consumer sentiment survey, for example):

Survey measures of longer-term inflation expectations have responded only a little to the larger fluctuations in energy prices that we have experienced, and for the most part they were low and stable last year. Inflation compensation for the period five to 10 years ahead, derived from spreads between nominal and inflation-indexed Treasury securities, has remained well anchored.

Bernanke mentioned a number of recent economic indicators in his assessment of the economy. His anecdotes were minor and he was thus more dependent upon government data. Perhaps he hasn't built up the contacts that Greenspan had. Maybe it's a sign he is stuck in the classroom.

... the most recent evidence -- including indicators of production, the flow of new orders to businesses, weekly data on initial claims for unemployment insurance, and the payroll employment and retail sales figures for January -- suggests that the economic expansion remains on track.

Bernanke emphasized flexibility throughout his testimony, a key trait that made for the greatest successes of Alan Greenspan's chairmanship.

... economic models can provide valuable guidance to policymakers ... But any model is by necessity a simplification of the real world, and sufficient data are seldom available to measure even the basic relationships with precision. Monetary policymakers must therefore strike a difficult balance -- conducting rigorous analysis informed by sound economic theory and empirical methods while keeping an open mind about the many factors, including myriad global influences, at play in a dynamic modern economy like that of the United States.

In sum, this leads me to reiterate a theme I have struck since last year: Treasury yields rarely trade below the fed funds rate except when an interest rate cut is on the near-term horizon. Therefore, with the funds rate likely to move toward 5% by the May 10 FOMC meeting, Treasury yields are likely to move in that proximity by that date, especially if the market sees risk in a 5.25% funds rate at the June 29 meeting.

Although Bernanke delivered testimony that was largely as expected, any rally associated with the apparent bearishness and anxiety that had built up in the weeks prior (for example, there was a substantial increase in the amount of speculative shorts in eurodollar futures contracts, the contract used to place bets on short-term interest rates in the U.S and the one with the most open interest of any contract in the world) won't likely go far, particularly in the bond market, which must adjust to the possibility of a 5% funds rate.

Stock investors could more easily shrug it off because the strong growth of the economy in the first quarter should boost revenue and hence, profits.

Tony Crescenzi is the chief bond market strategist at Miller Tabak + Co., LLC, and advises many of the nation's top institutional investors on issues related to the bond market, the economy and other macro-related issues. At the request of the Federal Reserve, Crescenzi is a regular participant in the board's Livingston Survey of economic forecasters. He is also the author of

The Strategic Bond Investor

. At the time of publication, Crescenzi or Miller Tabak had no positions in the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Crescenzi also is the founder of Bondtalk.com, a popular Web site covering the bond market and the economy. Crescenzi appreciates your feedback;

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