Updated from 7:20 a.m. EST
Chairman Ben Bernanke says the economy may be stronger than we think, but his reassuring words fly in the face of some of the soft economic data that have streamed in this week.
Thus far, the markets have been soothed by his testimony to Capitol Hill, and see the glass half-full. A string of weak reports, however, could bring economic slowdown fears and rate-cut hopes back into focus, misguided as that may be.
"The bond markets are on a tear with rate-cut expectations," says T.J. Marta, chief fixed income strategist at RBC Capital Markets. It also didn't take long for the fed funds futures market to shift back to pricing in 100% odds of a rate cut by the end of the year.
And, while the stock market believes the Fed is in neutral gear, if upcoming data is poor, "people might get nervous about the economy slowing more than Bernanke suggested," says Art Hogan, chief markets analyst at Jefferies & Co.
The markets are easily jostled by fears of a slowing economy and are quick to resurrect the "recession" question. But Bernanke's testimony on Capitol Hill this week reinforced that the Fed chairman is more concerned about the path of inflation than the path of growth.
"As I noted earlier, there are some indications that inflation pressures are beginning to diminish," said Bernanke in his testimony. But, he added, "the monthly data are noisy," and "it will consequently be some time before we can be confident that underlying inflation is moderating as anticipated."
Even with the chairman's attention to inflation risks, the stock market rallied to new all-time highs, relieved that he didn't shift back to a more hawkish tone. A hawkish trio of Fed officials' speeches last Friday spooked the markets ahead of Bernanke's testimony this week.
But Gentle Ben delivered the wine and roses that the markets were hoping for. His testimony to the Senate Wednesday was an expansion on the so-called neutral FOMC statement of Jan. 31. In his testimony Thursday to the House Financial Services Committee, investors heard more of the same.
On growth, Bernanke said: "We've seen some very strong consumer spending numbers and we've seen some strong income growth, which suggest that the economy may be stronger than we think."
And on inflation, Bernanke responded to House Finance Committee Chairman Barney Frank's combative question about why the Fed has a tightening bias amid a forecast for slowing growth. "If inflation becomes higher for some reason, the Federal Reserve would have to respond by raising interest rates," Bernanke said.
But the chairman also said the Fed would be data-dependent. "Policy is going to respond to new information," said Bernanke. "We are going to be continually re-assessing our outlook."
The outlook was characterized by a slightly lower forecast for economic growth than the Fed provided last July. Bernanke forecast GDP growth of 2.5% to 3% for 2007 and 2.75% to 3% for 2008. He expects unemployment to remain low at 4.5% to 4.75% in both 2007 and 2008. And Bernanke believes core inflation will run at 2% to 2.25% this year and 1.75% to 2% in 2008.
Thus far, this week's lackluster data does suggest slower growth than analysts expected at the start of the first quarter. Already, the government's initial estimate of fourth-quarter GDP growth at 3.5% has already been downgraded with recent reports of higher-than-expected wholesale inventories and a wider-than-expected trade deficit in December.
But the markets should require more dramatic evidence to start worrying about a hard landing, says John Lonski, chief economist at Moody's Investors Service.
Surely the game this year will be for the Fed to thread an even-narrower needle of reassuring the markets that somewhat slower growth is desirable to keep inflation in check, without launching another recession scare.
Friday's data suggested that the economy certainly isn't overheating. The January producer price index, a measure of wholesale inflation, was right in line with estimates, falling 0.6%. The core rate, which excludes food and energy, ticked up a tame 0.2%. Next week brings January's consumer price index report.
Meanwhile, housing starts were much weaker than expected to start 2007, coming in at an annual rate of about 1.41 million, compared with forecasts for a 1.6 million pace. Of course, cold temperatures and harsh winter weather across large parts of the U.S. in recent weeks have no doubt kept builders indoors in many areas.
Bernanke has warned that investors "shouldn't extrapolate too vigorously from monthly changes in economic statistics, at the risk of being badly misled," says Lonski. "He is confident the economy will grow, albeit at a slower rate than in 2006, and core inflation will continue to subside with slowing economic growth."
But January's flat retail sales figures, released on Wednesday, were a disappointment. Investors had hoped that the robust spending that marked November and December would continue in January given the extension of the holiday season. Analysts noted the weakness was due to declines in autos, gasoline and electronics sales, but even excluding autos, retail sales only climbed 0.3%.
Thursday brought a weak 0.5% decline in industrial production, an increase in weekly jobless claims, less robust capacity utilization and a soft, 0.6 reading on the Philadelphia Fed survey of manufacturing activity in the region. The bad news boosted Treasury market prices and provided stock investors with a bit of agita that kept Thursday's gains somewhat muted -- again the echoes of distant recession fears brewing.
Still, traders were reassured by Bernanke's soothing tone and a midday report of rising confidence among homebuilders. The National Association of Homebuilders sentiment index rose to a reading of 40, its highest since June 2006. Also, the New York region's Empire State manufacturing survey was pure Goldilocks, showing rising manufacturing activity and lower prices paid. The index jumped to 24.4, vs. expectations for a reading of 11. The
hit another new high Thursday, and the
rose to a new six-and-a-half year high.
Call him Gentle Ben, Zen Ben or Benign Bernanke, the Fed chairman won the heart of the markets this week once again. But every bedtime story ends, leaving us all alone with our thoughts -- which, in the case of the markets, lean to the fearful when weak economic data start to pile up. If only Ben could read to us every week, the market's rally might never end.
In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click
to send her an email.