In the wake of the midterm elections, some commentators have noted that
Chairman Ben Bernanke might have trouble setting an inflation target. Conventional wisdom says the victorious Democrats fret that inflation targets get in the way of economic growth.
Ben Bernanke has advocated inflation targets in the past, but the Fed has been averse to automating a response to inflation thus far in his chairmanship. Instead, the central bank has rested its credibility on a forecast that slower growth will reduce inflation.
The test for Bernanke comes not in the form of getting a target through Congress in the next few months, but whether the data prove out his "slow growth equals lower inflation" theory. With data on producer prices and retail sales on Tuesday (as well the minutes of the October FOMC meeting), plus consumer prices and housing starts data later this week, the heat is on.
"If they continue to see upward movement in core inflation, and if the economy looks reasonably healthy, it is a real credibility question for the Fed," says Ethan Harris, chief economist at Lehman Brothers.
In his July testimony before Congress on the state of the economy, Bernanke said he expects the Fed's favored measure of inflation, the core personal consumption expenditures deflator, to read between 2.25% and 2.5% by the end of the year, and wouldn't return to within the 1% to 2% comfort range until 2008. Core pce is currently running at a 2.4% year-over-year pace, well above the 1% to 2% level consistent with "price stability" Bernanke has cited several times in previous years.
While the Fed prefers the core PCE deflator, the markets and the central bank still pay close attention to CPI. In recent months, incremental increases in CPI have been below the market's psychological threshold of 0.3%, but just narrowly so. And CPI still runs at 2.9% year-over-year rate -- a high for this decade. In the past two months, core CPI rose 0.24%. With another 0.24% reading, the Fed might have to put a hike back on the table to stick to its word, says Harris. Consensus expects core PPI to rise 0.1% in the month, while retail sales are expected to decline 0.3% and PPI is forecast to fall 0.6%.
"If I'm at the Fed, I'm more worried about inflation now than I was four months ago," says Harris, who is forecasting a 0.24% increase for October CPI. But the big inflation worry now comes from the tight labor market, he says. Wages are rising as productivity levels off.
"It wouldn't take much in terms of economic growth to push unemployment toward 4%. That would put upward pressure on wages, which could cause the Fed to hike rates in 2007," says John Lonski, chief economist at Moody's Investors Service. "You just can't write off that possibility entirely."
The message from various Fed officials lately has been that the central bank will take action to combat inflation if necessary. The concern remains the sharp slowdown in the housing market and how that will hurt the U.S. consumer.
Dallas Fed President Richard Fisher provided the contrary take Monday, boosting stocks and causing bond traders to back of their recessionary outlook. The economy is "growing forcefully," said Fisher, eschewing hawkish talk on inflation.
Dow Jones Industrial Average
gained 0.19% to close at 12,131.88, while the
gained 0.25% to close at 1284.42. The
gained 0.70% to close at 2406.38.
The bond market reversed course on Fisher's statements but rallied back to higher levels at the end of the day. If this week's data point to a rebounding economy in the fourth quarter, bond investors will further question the market's deeply discounted yields relative to the fed funds rate. The current yields portend a hard economic landing and even recession. The 30-year Treasury bond lost 2/32 to yield 4.7%, while the 10-year note originally fell 11/32, but rallied back to end down 4/32 to yield 4.6%. The two-year note lost 2/32 to yield 4.76%.
Stocks were buoyed by gains in the tech sector as
both added over 2% after separately receiving positive comments from sell-side analysts.
Aside from Intel, shares of
American International Group
led the Dow, with gains over 1% each.
Among other stocks in the news, Shares of
gained 2.19% despite news that its CEO agreed to retire amid a stock options scandal, while
jumped 7.9% on news of a special $6-per-share cash distribution to shareholders.
The price of oil also helped boost stocks, as it fell 1.7% to $58.57 per barrel.
Dallas Fed President Fisher
recently took responsibility for cutting rates too low, on the back of poor inflation data, which fueled a housing bubble and excess liquidity in the system. Avoiding bubbles and scares over inflation or deflation are Bernanke and the Fed's objective. Indeed, Bernanke has advocated for better communication and better understanding of the Fed's processes and launched a subcommittee to address the issue.
So given the current credibility conundrum, if Bernanke is after an inflation target, it is not likely this year's business. The Fed could possibly adopt a broader range than 1% to 2%, but that might hurt its credibility, as it would seem merely cosmetic. Setting 1% to 2% in stone sounds counterproductive to the Fed's aim right now -- to hope slowing growth dampens inflation all on its own.
The Fed is more likely to keep its fingers crossed and hope its forecast proves true; that would be the ultimate credibility builder.
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.