Markets & Finance

A Mile in Bernanke's Shoes


Does slowing jobs growth mean the Federal Reserve's inflation-fighting job is near its end? Investors certainly seemed to think so on Aug. 4. After a mild employment report, futures markets were pricing in just a 20% chance that the Fed will pursue an 18th consecutive interest-rate increase at its Aug. 8 policy meeting.

Monthly employment data may have been the death knell for rate hikes (see BusinessWeek.com, 8/4/06, "July Jobs: Pretext for a Fed Pause?"). Nonfarm payrolls increased 113,000 in July, according to the Labor Dept., below economists' forecasts of 140,000, while unemployment rose from 4.6% to 4.8%. "The employment report seals the deal on a pause in the Fed's interest-rate hikes, and a continuation of the trend would spell the end of hikes for the current cycle," notes Tony Crescenzi, chief bond market strategist at Miller Tabak.

Nevertheless, the outlook for inflation, economic growth, and interest rates remains uncertain. Complicating the jobs report was a lack of government hiring in July and a 0.4% increase in average hourly wages, ruffling the feathers of inflation hawks. On Aug. 4, an opening rally on Wall Street fizzled as the Dow industrial average finished nearly flat.

TRICKY CURRENTS. After Aug. 8, the Fed is slated for three more meetings before the end of the year. A pause now could signal the end of the tightening cycle, or it might just be a breather before another hike later in 2006. Futures markets on Aug. 4 were showing a roughly 50% chance of a hike to 5.5% by late October.

Fed Chairman Ben Bernanke will have to navigate some tricky currents as he tries to steer the economy between inflation and recession. We surveyed five market-watchers to find out what they would do for the rest of 2006 if they were in the same boat as the Fed honcho. Their prescriptions range from zero to two quarter-point rate hikes. But they all agree that the economy is in the middle of a transition to slower growth.

Jack Ablin, Harris Bank

The Fed has most likely vanquished the inflation threat, according to Jack Ablin, chief investment officer at Chicago-based Harris Bank. With that in mind, an Ablin-led Fed would keep rates steady for the rest of the year. "The economy responds more quickly than inflation to Fed tightening," he says. "We're in that zone right now where the economy is rolling over but inflation still looks strong."

Ablin's caveat: It depends where the buck stops. The dollar fell to a two-month low against the euro in afternoon trading following the Aug. 4 employment report. A weaker dollar acts in effect like inflation, by raising the price consumers must pay for imported goods.

"If they have to defend the dollar, then that would get the Fed back into tightening mode," Ablin says. "But everything I see right now suggests that the Fed is done."

Keith Hembre, First American Funds

In a few months, inflation may no longer be the Fed's biggest concern. Slowing economic growth could spur the Fed to begin easing rates in early 2007, according to Keith Hembre, chief economist at Minneapolis-based First American Funds (USB). "I would expect a little more weakness in terms of housing and underlying consumer spending by the end of the year and the first part of next year," Hembre says.

Still, a Fed led by Hembre would monitor a couple of economic trends before unleashing rate cuts. Hembre would look for data to confirm that demand has slowed sufficiently and that a cooling housing market will keep it from picking up again. He'd also be checking for downward pressure on inflation following the last four months of below-potential job growth. "Policy changes would only reflect deviations from that road map," he explains.

Peter Kretzmer, Bank of America

What if inflation isn't defeated? Recent inflation readings have been consistently above the Fed's comfort zone, points out Peter Kretzmer, senior economist at Charlotte (N.C.)-based Bank of America (BAC). Kretzmer forecasts two more 25 basis-point hikes, which would lift the federal funds rate to 5.75% by the end of the year.

In fact, if Kretzmer had been in Bernanke's shoes previously, the markets would probably not be so primed for an Aug. 8 pause. "We've been consistently surprised at his optimism that it was just a matter of the economy slowing, and then inflation would head back downward," Kretzmer says.

Rising energy prices are the culprit behind continued high levels of inflation, according to Kretzmer. Front-month West Texas Intermediate crude oil futures settled at $74.70 on Aug. 4, up 22.4% for the year. A Kretzmer Fed would monitor not only core inflation figures, which exclude food and energy, but also inflation with those prices included.

"Focusing on the core when the headline and the core have been departing for so long has become a part of the problem," Kretzmer says. "Energy prices are an important part of the equation as well."

Bob Ried, Ried Thunberg

Energy costs also worry Bob Ried, president of New Jersey research group Ried Thunberg. Ried projects high inflation readings to continue amid rising oil prices, a weakening dollar, and limited slack in the economy, so his Fed would pause now only to hike rates again in November. "The risks are still just on the upside on inflation," he says.

A pause on Aug. 8 wouldn't leave policymakers much time before their next meeting, set for Sept. 20. However, inflation indicators could prompt a rate hike on Oct. 24, Ried says, with a pause likely again in December, when trading is seasonally slow.

For now, the spotlight will be on the actual text of the Fed's Aug. 8 policy statement. "Do they make a statement that this is indeed a pause, and not necessarily a harbinger of eas[ing]?" Ried asks.

Quincy Krosby, The Hartford

Quincy Krosby, chief investment strategist at The Hartford (HIG), would say yes. Krosby continues to focus on rising prices and wages as well as the risk of a hard landing in the housing market. "If the Fed pauses, I believe there will be a hawkish statement that will tell the markets, 'We are vigilant,'" she says.

From there, a Krosby Fed might take a more data-dependent tack. "When all is said and done, we are close to the end," Krosby says. "The Fed is slowing down the economy, so prices will come down accordingly and, ultimately, so will wages. But this period has data that are conflicting, and that's always the way it is."

As our survey of Fed-watchers suggests, whether or not the central bank's rate-hiking duties are complete, Bernanke and company still have a big—and tricky—job ahead.


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