GOP Fears Fed Ben May Overshoot Their Interests

Posted: Feb 17, 2006 8:41 AM

WASHINGTON -- Federal Reserve Board Chairman Ben Bernanke has reassured market observers and investors that the economic expansion is still right on track this year. But he dodged the all-important question about whether the Fed will continue to raise interest rates.

In his long-awaited debut before a congressional committee in his new role as Fed chairman, Bernanke delivered the pivotal economic message the White House wanted to hear most: that the Bush economy is not only continuing to show strength, but that it has "staying power."

Wall Street's reaction to that news was less than enthusiastic. The bears had heard this before and most doubted that Bernanke's crystal ball could accurately look that far into the future. The Dow rose a timid 30 points after his testimony.

He answered many questions from members of the House Financial Services Committee, but the question of whether he'll continue former Fed chairman Alan Greenspan's inflation-fighting rise in interest rates was not one of them.

Bernanke was supposed to bring more transparency and clarity to the Fed's explanations, but his answer to the interest-rate question was nearly as opaque as Greenspan's famously long-winded, circuitous responses.

When Greenspan was asked last June about where interest rates were headed, he answered this way:

"(W)e probably will know it when we are there, because we will observe a certain degree of balance which we had not perceived before, which would suggest to us that we're somewhere very close to where the rate is."

When Bernanke was asked about future interest rates, he replied, "I can't comment directly on short-term interest rates."

That terse but direct nonresponse was perhaps a refreshing change from Greenspan's famously impenetrable language. Still, it left the financial markets worried that they could be facing several more interest-rate hikes, which some fear would short-circuit the expansion in an election year.

While it's true that the economy was sending all the right growth signals over the past month in almost-weekly government reports that showed job creation, retail sales and factory production were up, that didn't necessarily translate into excessive inflationary pressures that the Fed fears.

Let's not forget that the gross domestic product, which measures the economy's growth rate, rose by a tepid 1.1 percent in the fourth quarter. That is hardly a sign of an overheated economy getting ready to unleash a burst of runaway inflation.

Inflation as measured by the personal consumption expenditure price index, excluding energy and food, inched up 2.9 percent in the third quarter, a relatively modest rise in an expansionary climate.

This is why economy watchers are worried that Bernanke will misread his economic tea leaves and raise interest rates longer than necessary. The long march upward in quarter-point hikes may seem harmless at the Fed, at least in the short-term, but it's their hidden long-term impact that we should be concerned about.

"When the Fed raises rates, it takes six to 12 months for the effect of rate hikes to be felt in the economy," said global economist David Smick, who publishes the International Economy magazine.

"If you wait until you see signs of weakness by raising rates, you will generally overshoot in the context of monetary policy because once the weakness appears you still have six months of the effects from tightening still to come out," Smick told me.

"So since the economy is strong, the Fed will probably overshoot. The question is whether it happens this fall or in 2007," he added.

That scenario is very problematic for the Republicans and the White House, who don't want to see any softening in the economy this fall when control of the House and Senate will be up for grabs.

There is a general consensus among economists here that the Fed will raise interest rates another notch to 4.75 percent when the Federal Open Market Committee meets next on March 28.

Bernanke sent that signal last week when he said that "some further firming of monetary policy may be necessary." And he may be prepared to raise rates several times more to reach his inflation targets. He has cited a 1 percent to 2 percent target in the past.

That inflationary level might require some significant tightening, beyond what pro-growth advocates would like in an economy that has been buffeted by some pretty strong head winds in recent years. That's why Dave Smick is appropriately worried about "the lag time" of the Fed's actions under Bernanke's chairmanship. "Let's say that the core inflation rate tops out right now, but you will still have another six months in the pipeline of tightening. It always takes a lot of courage for the central banker to stop," he says.