Federal Reserve chairman Ben Bernanke’s semi-annual congressional testimony soothed the bond markets. The 10-year treasury bond gained ground, and its yield fell nearly seven basis points to 5.01%. Nevertheless stubborn consumer inflation, slow economic growth and unexpectedly low productivity growth may at some point cause a market crisis.
Then, Bernanke’s balms will be of little value.
June’s consumer price inflation was slightly worse than the market expected. But more worrying was the fact that annualized inflation over the first half of 2007 was 5%. That suggests the 5.25% Federal funds rate is too low.
Bernanke himself admitted that the 4.4% rise in his preferred inflation indicator was “inconsistent with the objective of price stability”.
He continues to expect inflation to decline below 2% soon, but he’s been saying that for over a year, and it has not done so. There are a number of problems with the Bernanke worldview. Productivity growth has been well below its historical average since the fourth quarter of 2005. Second quarter gross domestic product and productivity figures, which will be out at the end of July, will probably reflect continued sluggishness. Economic growth has been hit by the deepening collapse of the housing market. June housing starts were 19% below the year earlier period and building permits were down 25%. Since employment data has been quite strong throughout 2007, a weak GDP figure will signal abysmal productivity growth. If productivity growth is weak, inflation will be higher than would be historically expected, given the level of economic growth. If Fed continues to underestimate inflation and overestimate the potential US growth rate, monetary policy will go on being too slack.
The stock market has had a wonderful few months, but if it wakes to the reality of stubborn inflation and low growth, higher long term interest rates and lower stock prices will be inevitable.
That awakening is unlikely to be pretty, and Bernanke will be a natural scapegoat.