Growth - Not Inflation - Remains the Fed's Main Concern

By Jason Simpkins

Associate Editor

U.S. Federal Reserve Chairman Ben S. Bernanke yesterday (Wednesday) echoed Vice Chairman Donald Kohn's earlier view that market turmoil and slowing growth pose the "greater threat" to the U.S. economy, a comment that clearly relegates inflationary concerns to the back burner.

"The Federal Open Market Committee will be carefully evaluating incoming information bearing on the economic outlook and will act in a timely manner as needed to support growth and to provide adequate insurance against downside risks," Bernanke said in testimony before the House Financial Services Committee in Washington.

Fourth-quarter gross-domestic-product (GDP) growth relaxed to 0.6%, and the first quarter of 2008 hasn't looked all that promising. Durable-goods orders fell 5.3% in January. The Conference Board's consumer confidence index plunged to a reading of 75 Tuesday, its lowest since March 2003.

Earlier this month, the Institute for Supply Management announced that its non-manufacturing index, a measure of the American service sector that reflects almost 90% of the economy, fell to 41.9 in January, down from 54.4 in December. A reading under 50 indicates an economic contraction. The decline was the largest in the survey's 10-year history and the first time since March 2003 that it signaled a decline in service sector activity.

The housing sector also remains in disrepair, as home prices fall to historic lows and foreclosures reach all-time highs.  According to the S&P/Case Shiller Home Price Indices, home prices fell 8.9% in 2007, the largest ever year-over-year decline. New home sales slipped 2.8% in January to a 13-year low.

In response, the Fed has slashed its benchmark Federal Funds Rate by a total of 2.25 percentage points since September. It now stands at 3%.

However, as economic growth continues to stagnate, inflation is ramping up.

The Labor Department reported Tuesday that wholesale food, energy and medicine costs soared in January, pushing inflation to its fastest pace in a quarter century.  Producer prices jumped by 1% for the month, more than double the increase analysts expected. Over the past 12 months, producer prices soared 7.4%, the most since October 1981.

The producer price index was the last of three major Labor Department reports on January's inflation rates. The first two, the consumer price index and import prices were equally dismal. Consumer prices rose 0.4% in January, while import prices increased 1.7%.

Yesterday, the dollar hit an all-time low against the euro when it sank to a value of $1.5105 per euro, its lowest mark since the euro's 1999 debut. The greenback has slipped 4% against the euro in the past three weeks.

Some analysts had previously suggested that higher levels of inflation would dampen the Fed's rate-cutting enthusiasm, but that doesn't appear to be the case.

"I do not expect the recent elevated inflation rates to persist," Vice Chairman Kohn said in a speech prepared for delivery Tuesday at the University of North Carolina at Wilmington. "In my view, the adverse dynamics of the financial markets and the economy have presented the greater threat to economic welfare in the United States," Kohn said.

Chairman Bernanke said yesterday that further increases in commodity prices and the recent data collected on consumer prices "suggest slightly greater upside risks to the projections of both overall and core inflation than we saw last month."

Bernanke did note that "any tendency of inflation expectations to become unmoored, or for the Federal Reserve's inflation-fighting credibility to be eroded, would greatly complicate the task of sustaining price stability and could reduce the flexibility of the FOMC."

"Accordingly, in the months ahead, the Federal Reserve will continue to closely monitor inflation and inflation expectations," Bernanke said.

Still, Bernanke was careful to emphasize downside risks to growth as his main concern and left open the possibility for further rate cuts at the Fed's next meeting March 18. Futures indicate that traders anticipate the Fed will cut rates by another half a point by that time.

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