No replies to this topic

[Tor]

Bernanke Post-Mortem: Just What the Doctor Ordered — The Inflation Swelling Has Gone Down The five key takeaways from Fed Chairman Bernanke's semi-annual testimony delivered to Congress today are as follows: 1. GDP growth is seen moderating into a 2½% to 3% range in 2007 — this was cut from 3% to 3¼% six months ago — with no real acceleration in store for 2008 (2.75-3.0%); 2. There seemed to be more emphasis on the downside risks to growth from any housing market spillover than upside risks from demand growth holding firm once the inventory correction underway in manufacturing and residential construction runs its course (ie, the personal savings rate fails to increase); 3. Almost all the risks to inflation are now seen to the downside — oil, commodity prices (and their flow-through into "core"), anchored inflation expectations and an easing in rental rate pressures. The only upside to inflation is seen if the economy re-accelerates above its potential growth rate given the "high level of resource utilization". Meanwhile, we are seeing clear signs now that these resource utilization metrics are abating with the unemployment rate now at 4.6% from the 4.4% bottom in October; and tomorrow we will likely see the industry CAPU rate drop to 81.4%, which compares to the 82.4% peak seen last August. To be sure, the "central tendencies" in the FOMC projections are for core inflation to drop below 2% in 2008 (2.00-2.25% this year; 1.75-2.00% next), but in our view, the Fed has set itself up for a potential downside surprise on this front as we expect a "1-handle" on the y/y core deflator to emerge as early as April-May. 4. While the Fed Chairman still believes that productivity trends are "favorable", he addressed labor market shifts ("impending retirement" of baby boomers; "leveling out" of the female participation rate) as being one reason why potential GDP growth may have come down — and it does seem as though, based on the forecasts provided through 2008, that "potential" is now seen in a 2.75-3.00% range than 3%+ as was implicitly assumed previously. Then again, what matters most for inflation is what actual demand does relative to potential, and on this score, Dr. Bernanke stated that "the risks to this outlook are significant". As we said, the Fed Chairman started off this segment with the downside risks — not the upside risks — and this where the emphasis was placed. In fact, he uttered 42 words on what could drive the GDP forecast down and 23 words on what could emerge as the upside growth surprise for a near 2-to-1 ratio in favor of the downside risk to the macro call. Bernanke made the important point that even if housing demand stabilizes — and that is still a big "if' — there is still considerable downside to construction just to clear out the current inventory backlog. Also keep in mind as well that the Fed's projections were taken at a time when the Commerce Department told us that fourth quarter growth was 3½%; and it now seems as though it will be closer to 2% (not at any time in the past 15 years was there such a huge potential for downward revision between the first two GDP estimates as what we are experiencing now). In fact, in his opening remarks, Dr. Bernanke stated that GDP growth came in at "about 2¾% in the second half of the year". If the current "bean count" based on the past week's data flow is any indication, growth came in much closer to 2% or 3/4 of a percentage point below the estimate provided today by the Fed Chairman. The bottom line is that the Fed has a forecast of modestly below-trend growth this year with little pickup next year, which allows the unemployment rate to stay in a 4.50-4.75% range and core inflation, with a lag, to dip to a 1.75-2.00% range next year. One can certainly paint a "stay-on-hold" view from this prognostication, but we highly doubt that the Fed hikes rates at any time based on the information provided today unless somehow demand ends up accelerating above growth in available supply once the inventory overhangs are worked through. We would place no higher than 10% odds of this happening. And we place no higher than 50% odds that the Fed's nirvana view that growth coasts along a 2.5-3.0% path indefinitely, with the unemployment rate merely stabilizing and core inflation only nudging below the 2% threshold in 2008 — though such a forecast itself would warrant, at some point, a withdrawal of the Fed's restrictiveness which would be anywhere from 50-100 basis points of rate cuts depending of course on whether potential is closer to 2.75% or 3%. From our lens, timing and magnitude are the key issue rather than the direction of interest rates. If our macro forecast comes to fruition (core inflation at 1.7%; unemployment rate at 5%; savings rate at -0.5%) by the time the next semi-annual congressional testimony rolls around in July, then we would expect to see a stronger signal from the Fed Chairman regarding a shift in policy in the second half of the year. We are not backing away from that view. Bonds and stocks are rallying in tandem today, just as they did in the aftermath of the 31 January post-meeting press statement because the Fed has acknowledged that inflation risks have faded even if they remain, as Bernanke put it, "the predominant policy concern" — but only because of the current levels of resource utilization rates. These rates are in the process of easing up, which in turn means that at some not-too-distant point in the future, the Fed will be able to switch to a 'neutral' risk assessment. Then watch the sparks fly — especially in the Treasury market — because a shift in the de facto 'bias' will be the real signpost that the Fed is about to switch gears. To be sure, there are some pundits who believe that the Fed can only begin to cut rates once core (PCE) inflation is at the so-called midpoint of its 1-2% target band. We don't buy into that view. In late 2002, at one of Bernanke's first FOMC meetings as a Governor, he voted to cut the funds rate 50 basis points to 1.25% and at that time the core inflation rate was running at 1.7%. No doubt there were concerns over the sustainability of growth and the size of the output gap at the time. But it just goes to show that even the most ardent inflation-targetter is not necessarily going to wait for core inflation to hit the midpoint of a range as long as growth slows enough to generate excess slack in the economy — especially if, as we have been told by a few Fed officials of late, policy is already in a moderately restrictive state. Finally, we believe that Bernanke deserves kudos for delivering a concise and clear ('obfuscation free') sermon today on the outlook and the risks. He seemed much less nervous over the inflation landscape than at his previous two testimonies, but perhaps this is because the data have broadly come in line with his thinking. Not only that, but what struck us in the testimony was how Bernanke focused on the Fed's actual mandate and the task at hand which is about domestic growth, unemployment and inflation. No mention of the equity market hitting new cycle highs or the Dow hitting all-time records. No mention of emerging markets, private equity, credit spreads, Asian central banks, so-called bond market conundrums, global liquidity, low market volatility, or hedge funds for that matter. In fact, the only "asset" that Bernanke mentioned was housing — since this sector feeds right into GDP — and the only "market" of concern was the recent action in sub-prime mortgages and the sharp run-up in delinquency rates.