Financial Times Editorial - Bemused Bernanke

Financial Times Editorial - Bemused Bernanke
Copyright The Financial Times Limited 2006
Published: December 11 2006 02:00 | Last updated: December 11 2006 02:00


Most people would agree that, 10 months into the job, the new chairman of the Federal Reserve has not had the smoothest of rides. In that time, Ben Bernanke has had to deal with a slowing economy, large currency moves, volatile oil prices and difficulties communicating with the markets. The top job at the Fed has clearly become much harder. But with some luck, Mr Bernanke may still be able to manage it.

The strong economic expansion that started in 2002 came to an end this year, with the last two quarters showing a noticeable moderation in output growth. In the past month, data have become increasingly choppy. Some indicators, especially those relating to the housing market and consumer confidence, portray a weakening economy. Others, such as the strong payroll job creation numbers last Friday, paint a still resilient picture.

Inflation has moderated recently, thanks to favourable comparisons with last year's spike in oil prices. But excluding oil, inflation is still persistently high, reaching up to 2.9 per cent in the past three months. In spite of adopting a "wait and see" policy since August, keeping interest rates at 5.25 per cent, the Fed is still more concerned about high inflation than weaker growth.

However, the Fed's view that interest rates are more likely to go up than down is not shared by the market. Some of this is down to how Mr Bernanke has communicated recent policy decisions. But mostly, the divergence of views is due to the fact that the job of predicting where the economy is going has become much harder.

There are two reasons. First, it seems that the rate of potential growth is declining. The US economy has enjoyed a period when both the size of the workforce and its productivity have expanded strongly. Now it seems that the retirement of the baby-boom generation and a deceleration in female participation growth will lower potential from more than 3 to about 2.75 per cent. A lower rate of potential growth does not imply any specific interest rate reaction. However, the Fed must monitor the economy's changing capacity, as this will ultimately determine future inflationary pressures.

Second, Mr Bernanke's job has got much harder because the economic cycle is about to reach a turning point. The slowdown in growth has been led by a cooling in the housing market. The pessimists argue that most of the pain is still to come, requiring sharply lower rates in the first half of 2007. The optimists believe that the rest of the economy will be able to sustain activity, even in the face of a weaker dollar.

Achieving a soft landing is never easy. In the US, cyclical and structural factors make it even harder. On balance, the Fed's view that the economy remains resilient and inflation is the bigger risk is probably correct. Mr Bernanke now has to persuade the markets to share his optimism.