Fed Chief Comments of Economic Outlook

In an effort to reassure American consumers, Federal Reserve Chairman Ben Bernanke told a concerned Congress yesterday that he doesn't foresee the $13 trillion U.S. economy slipping into recession.

Bernanke, the chief economic prognosticator of the federal government, was seeking to calm fears that troubles in the subprime mortgage sector might spread to the broader economy.

"At this juncture ... the impact on the broader economy and financial markets of the problems in the subprime markets seems likely to be contained," he said.

While his public comments were designed to encourage Wall Street, stocks dropped sharply in response.

The faltering housing market, which has been in a slump for the past year, has greatly contributed to the slowdown in the economy. According to Standard & Poor's/Case-Shiller Home Price Index of major metropolitan areas, the average price of single-family homes dropped in January, the first year-over-year drop since January 1994.

The downward pressure on home prices has been caused in part by foreclosures and an increasing inventory. And the collapse of the subprime market has significantly shrunk the housing market as a whole. According to Moodys.com, about a third of last year's new home buyers would be rejected for a loan today.

Bernanke's biggest concerns are twofold: the risk of higher inflation; and weaker-than-expected economic growth. As a result, last week the Fed announced that interest rates could possibly go up or down.

If the economy falters and growth slows, the Fed would be motivated to lower interest rates in order to make money more affordable. That, in turn, could encourage spending and investment and spur economic growth. On the other hand, if inflation picks up, the Fed could raise interest rates in an effort to cool the economy and tamp down inflationary pressures.

Previously, Bernanke had only spoken of the possibility of rate increases, since the economy is expected to maintain a pattern of moderate growth this year. And on Wednesday he reiterated that inflation is still his biggest concern.

"I do want to emphasize we have not shifted away from an inflation bias, " the Fed chief said.

That's good news for those worried about slower economic growth, but not so appealing to those worried about inflation.

The national unemployment rate remained at a historically low 4.5 percent in February, and workers saw slight wage increases. A tight labor market results in higher wages, which could further drive inflation. Conversely, when unemployment is high and people are desperate for work, wages generally drop in response. That, in turn, usually cools inflation.

As confidence has slipped, business investment has weakened, which could further suppress economic growth.

But, truth be told, inflation is still running at the historically low rate of just over 2 percent annually. For most of the twentieth century (1914-2000), inflation averaged 3.5 percent.

The biggest hope for the U.S. economy is it's primary fuel; consumer spending. The spending habits of American consumers account for 70 percent of U.S. economic activity. Maintaining their confidence is critical. Right now their biggest concerns seem to be the housing slump and gas prices, which have risen for eight consecutive weeks. The increased cost of fuel, by itself, could spur inflation since all goods, as well as people, rely on shipping and transportation.

Consumer confidence fell this month, and restoring that confidence could well be the elixir that the U.S. economy needs at this moment.
More spending won't help the negative savings rate, but it will help the economy continue the period of sustained growth that it has experienced for the last five-plus years.

Copyright © 2007 Sean M. Kennedy. All rights reserved. This material may not be published, broadcast, rewritten, or redistributed without the author's consent.