Has Bernanke Blown It?

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The stock market sure seemed to love Ben Bernanke's optimistic testimony before a Senate panel yesterday, with the Dow Jones industrial average hitting a record high on the news and adding to its gains today. "There are some indications that inflation pressures are beginning to diminish," the chairman of the Federal Reserve said. At the same time, the Fed predicted that 2007 economic growth would come in somewhere between 2.5 percent and 3 percent, about a half point lower than its July forecast because of the housing slowdown. Overall, the Fed chief sees moderating inflation and moderate growth, obviously not a bad outlook as Wall Street sees it.

But when I checked out the Intrade betting market for the odds of a recession happening in 2007, I found that the chances of a downturn had actually crept up a bit from 19 percent to 21 percent. I think the reasoning behind the move can be found in this Fed analysis by David Gitlitz, chief economist at TrendMacrolytics:

But the rally in gold, which traded above $670 during Bernanke's testimony, and the concomitant decline in the dollar, tell us that however overzealous the fixed-income response might have been, indications that the Fed's current inflation-biased pause might remain in place indefinitely were sufficient to further intensify the looming inflation risks. . . . The longer the Fed waits to restore monetary equilibrium, the more it will need to do and the greater the risk that significant economic damage will ultimately be incurred. That was the message in today's moves in gold and foreign exchange. Our suggestion that the Fed might now be on track to resume the rate-hiking exercise at the May meeting should probably be pushed back. But policymakers will at some point face the unavoidable reality that their task remains incomplete and a resumption of the process of restoring monetary equilibrium is inevitable.

In short, Gitlitz thinks that the rise in gold indicates inflation is still a problem and the longer the Fed goes without raising interest rates, the more draconian future moves will have to be┬ľand that raises the risk the Fed will push rates too far and push the economy into a recession. Of course, the bullish $14.7 trillion stock market has a different take on things.

Blogger Feedback: About my recent posting "Bush's Secret Plan to Save Social Security," where I contend that higher labor productivity growth would greatly diminish Social Security's solvency problems, The Everyday Economist writes, "Forecasting 3 percent productivity growth is a bit far-reaching. I think more than anything, this signals that the Bush administration has given up on any type of reform effort. This is bad news for private accounts and potentially good news for high-income earners." And Andrew Samwick, former chief economist for President Bush's Council of Economic Advisers and author of the Vox Baby blog, points out that "it would be quite a stretch to suggest that productivity growth could continue at the rate we've seen in the last decade. Such an assumption would presuppose that we could experience something akin to the initial growth of the Internet every decade. That said, I do think the [Social Security administration] assumptions about productivity growth are a bit low. And higher productivity growth does improve the finances of a pay-as-you-go system. But I have also noted that I think the assumed rate of improvement in longevity is too low in SSA's projection model, and this tends to worsen the financial picture."