Fed Chairman Bernanke faces a tricky messaging problem for his July 17 Humphrey-Hawkins swan song before the Congress. Since his musing about the possibility of “tapering” Fed bond purchases while responding to pointed questions from JEC Chairman Kevin Brady, interest rates have risen sharply, by over a full percentage point (more in “real,” or inflation-adjusted terms) while the economy has slowed and inflation measures have dropped further to below a 1% pace by some measures.
Fed forecasts of stronger second-half growth have been undercut by weaker data that has driven the latest (second quarter) growth forecasts from about the 2.5% pace that prompted the taper musing to 1.0% or below during the two-month interval between Bernanke’s testimonies to Congress. Notwithstanding the Fed’s oddly persistent optimism, driven in part by a housing recovery that has been jeopardized by the sharp interest rate increases driven by taper talk, the US economy has slipped toward stall speed. Little wonder, with a persistent European recession, slower Chinese growth, and persistent US fiscal drag worth about two percentage points of GDP more than offsetting the boost from housing.
The tricky part of Bernanke’s messaging problem remains the stock market, which has kept rising as investors have shrugged off the taper-driven jump in interest rates by assuming, encouraged by rosey Fed forecasts, that higher growth and better profits will trump any drag on stocks and the economy from higher market and real interest rates. If Bernanke sticks to the higher-growth-taper theme, FOMC hawks will pounce, insisting on tapering QE sooner or even higher fed-controlled interest rates. The further rise in interest rates will jeopardize the housing recovery and and higher stock prices. If, alternatively, he expresses doubts about the Fed’s rosy outlook, rates will come back down and stocks will rise further against a backdrop of deteriorating profits that eventually will puncture the stock market rally. All very awkward with unemployment still stuck at 7.6%, growth close to zero, and inflation still falling.
There are no good alternatives facing Bernanke for now. The best he can do is admit to the slowing economy and return to the original QE 3 messaging plan: monetary policy will remain highly accommodative until unemployment comes down to 6.5% or below and/or inflation gets above 2.5%, something, he can point out, that is highly unlikely given a slowing global economy and the attendant, persistent drop in US and global inflation… no “ifs,” “ands,” or “buts.”