Drawing a Bead on Bernanke

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The chairman will be working these concerns into his testimony, with potential references to headline inflation that may stir market rumors that the Fed is looking to target a headline figure. Of course, we doubt that the Fed would take such a step, but rumors such as these reflect the more useful observation that a tracking of headline inflation is an important part of the Fed's overall inflation assessment.

Real Estate Concerns

Finally, recent housing data have suggested that we will be seeing continued weakness in real estate indicators such as new home and existing home sales over the coming months as inventories are unwound, with associated weakness in housing starts. Yet, the downward path for price indicators from the real estate market appears to be losing some steam. And the monthly construction spending reports have posted steady gains from a January trough. Associated construction employment data confirm that robust growth in nonresidential, public, and home improvement activity has largely contained housing weakness to the single-family home segment.

So what does all this mean for the market's likely response to the chairman's testimony? The Fed funds futures market has largely priced out any risk of a Fed easing through the rest of the year, and we doubt the chairman will want to say anything that encourages the market to price in a Fed tightening at this time.

Relevant Rhetoric?

The more subtle risk, in our view, is that the chairman's propensity to work his inflation concerns into responses to Banking Committee questions will appear in contrast to the eagerness of committee members to discuss the more headline-grabbing topics of subprime and credit market woes. While legislators' questions will dwell on downside economic concerns, Bernanke's answers may shift toward upside inflation concerns.

Whether Bernanke will prove as adept as Alan Greenspan at answering these questions without saying anything to spook the markets has yet to be seen. But, we do know that Bernanke elaborates more than Greenspan on economic views, while also sticking to the script. And, in this regard, the boost in the Fed's inflation rhetoric in the last statement raises the risk that the market may not be ready for a word-for-word restatement of the Fed's official position from its last policy meeting, with associated elaboration.

For the Fed outlook, we think the market may be underestimating the potential for the statement at the August FOMC meeting to further raise the tone of Fed inflation concerns. Risks here depend on the inflation news in the upcoming PPI, CPI, and PCE chain price reports, as well as the July round of employment data and the second-quarter GDP data with its associated annual revisions. If we get significant upside surprises in any of these reports, and if the economic outlook continues to improve accordingly, the August statement may be reworded in a way that opens the door for an imminent Fed tightening.

Englund is principal director and chief economist for Action Economics.