But how will investors know when to hold 'em and when to fold 'em? The key lies in the Fed's forecast for economic growth. Policy moves in the months ahead will most likely depend more on future growth than on the pattern of inflation. Policymakers generally expect real gross domestic product to grow 3 1/4% to 3 1/2% this year, measured from fourth quarter to fourth quarter.
But look what those numbers imply. Given the economy's first-half pace of about 4%, growth in the second half will have to average in the neighborhood of 2.5% for that projection to hold up. That's quite a slowdown. In coming months, any sign that the economy's pace is not cooling off to that degree would raise concerns at the Fed -- and on Wall Street -- that inflation will not ease back next year, and more rate hikes will be needed.
The stakes are especially high on the Fed's growth forecast. That's because policymakers now appear willing to accept slightly more inflation in the coming year, compared with their February forecast, in the belief that slower growth will allow inflation to recede in 2007. The Fed sees its favored price gauge -- the price index for personal consumption expenditures (PCE) excluding energy and food -- rising 2 1/4% to 2 1/2% this year, then dipping into the range of 2% to 2 1/4% in 2007. But those numbers are well above the oft-stated 1% to 2% "comfort zone" of many policymakers.THE FED'S FORECAST and Bernanke's testimony significantly altered Wall Street's mindset on the path of future policy. That much was clear from the market reaction -- or lack of reaction -- to the June consumer price index. The report came out on the morning of Bernanke's exchange with the Senate Banking Committee, and it was not at all market- or Fed-friendly.
The overall CPI rose 0.2% from May, but the core index, which excludes energy and food, jumped 0.3% for the fourth month in a row. It was the previous string of similar increases that had so alarmed the markets about inflation and the Fed's response. The rise meant that core inflation for the first half of the year was running at an annual rate of 3.2%, the fastest six-month pace in more than a decade. However, by the end of the day, the Dow had soared more than 200 points, and bond prices jumped, sending yields lower.The Fed's big bet is on the time lags involved with policy changes and their impacts on growth and prices. As Bernanke noted: "The lags between policy actions and their effects imply that we must be forward-looking." Some of the influence of past rate hikes, he said, is "still in the pipeline." Moreover, inflation tends to lag behind the ups and downs in the economy's growth rate, so slower growth is imperative both for inflation to recede and for the markets to stay buoyant.BERNANKE'S MARKET-SOOTHING REMARKS echoed the tone of the Fed's statement after the June 28-29 policy meeting. The recently released minutes of that meeting show that policymakers listed three reasons why this year's uptick in inflation would moderate in the coming year, including "contained inflation expectations, the abatement of upward pressure from past increases in energy and other commodity prices, and the slowing in the growth of economic activity that was under way."
In fact, based on one unusual reason given for the June 29 rate hike, the Fed seems to be leaning toward taking a pause at its Aug. 8 meeting. Officials agreed that tough talk on inflation leading up to the June meeting had lowered market expectations of inflation. Maintaining those tamer expectations, they said, all but required the Fed to hike rates -- not because of the patterns in economic growth or inflation but simply because the markets expected a hike.
Bernanke also played down some of the recent rise in the core CPI, noting the large influence of that gauge's rent-based measure of housing costs. This index is now producing the odd result that housing costs are rising instead of falling as housing markets weaken. In response to a question, Bernanke said that was one of the reasons the Fed preferred to look at the core PCE price index, in which this technique for measuring housing costs has a much smaller weight.
One big reason why the Fed appears so sanguine over the inflation outlook is the failure, at least so far, of wages and other labor costs to push prices higher. Productivity has been too strong to allow that. The Fed's Monetary Policy Report, submitted to Congress with Bernanke's testimony, noted that while productivity growth has slowed over the past two years, it is still matching the solid pace of the second half of the 1990s.
Strong productivity gains are a key reason why profit margins have soared to an all-time high in this business expansion, and Bernanke said he believes that high efficiency and margins will eventually allow wages to rise faster without putting undue pressure on prices.THE QUESTION FOR THE NEXT FEW MONTHS is this: Will the markets be as tolerant of the recent pickup in inflation as the Fed appears to be? That will depend on whether the upcoming growth-related data support the Fed's forecast for a cooler economy at a time when the need for slower growth is becoming more urgent. The economy appears close to running out of spare production capacity needed to meet new demand. The industrial operating rate is at a six-year high, and tight job markets have pushed unemployment down to a five-year low, a situation that could pressure prices even more.So far, the numbers, especially for housing, are playing out the way the Fed and the markets would like. Home demand continued to weaken in the second quarter as June sales of existing homes dipped 1.3% from May, amid rising home inventories and a continued slowdown in the rate of price increases. Builders are reeling. Starts of new homes fell in June for the fourth month in the past five, capping off the weakest quarter for starts in three years.
However, consumers remain surprisingly optimistic. Neither Mideast turmoil nor higher gasoline prices prevented consumer confidence from rising in July for the second month in a row. The Conference Board's survey said that household attitudes toward the job markets remained upbeat.
The consistent resilience of consumers and the overall economy remains the biggest risk in the Fed's forecast. But perhaps the most important reason why investors should be wary of the policymakers' outlook is that they are projecting a picture-perfect result for both growth and inflation. Economic forecasts are rarely that good. By James C. Cooper