Fed Chairman Turns Up the Hawkish Rhetoric

In a speech this Monday evening at a Federal Reserve Bank of Boston conference, Bernanke acknowledged that—so far—the pass-through of raw materials costs to the prices of other products and to labor costs has been limited, but said that the continuation of this pattern was not guaranteed. He said that the Fed would "strongly resist" an erosion of longer-term inflation expectations.

On the growth front, Bernanke signaled a shift in view. Although he acknowledged that the current quarter is likely to be weak, he said "the risk that the economy has entered a substantial downturn appears to have diminished over the past month or so." He gave this view despite last week's jump in the unemployment rate, which suggests that he views that jump more as bringing the rate into line with other labor market indicators, rather than signaling a new, much steeper phase of labor market deterioration.

This shift in view does not mean that growth risks have disappeared—after all, Bernanke said that growth risks remain to the downside, because of the continuing housing downturn and still-rising energy prices. But the change in tone is significant, given the risk management approach to policy-making adopted by the Fed. If interest rates have been cut to 2% in order to guard against the worst-possible outcome—a vicious downward spiral in which the credit markets crisis pulls down the economy, which in turn exacerbates the credit markets crisis—then if the risk of that outcome is reduced, it may no longer be appropriate to keep interest rates so low.

This means that the Federal Reserve does not need to see much, if any, improvement in the economy to justify a rate hike—it just needs to see a stabilization, which would allow it to turn its attention to inflation risks.

Given Bernanke's comments, it would be no surprise if the Fed's June 25 meeting declares inflation to be the main risk, rather than growth. That would not necessarily mean an early hike in interest rates. Our forecast does not include a rate hike until 2009, since we believe that the economy will be very weak in the fourth quarter of this year and the first quarter of next year, after the boost to consumption from the fiscal-stimulus package wears off. We do not think that either the economy or the credit markets will be in solid enough shape to warrant a rate hike this year.

But if the Fed keeps stepping up the rhetoric, and there are no more financial "accidents" in the near future, a hike may become inevitable. Economic activity data in the immediate future are likely to look a little better, as the fiscal-stimulus package takes effect. Meanwhile, headline CPI inflation will probably rise above 5% in the third quarter as high oil prices push gasoline prices up further. Jawboning inflation expectations down can only go so far without being backed up by action. Having ramped up the rhetoric, the Fed may decide it has to respond with a rate hike in order to maintain its inflation-fighting credibility.

It is also worth noting that the Federal Reserve is not the only central bank getting more worried about inflation. Last week, the European Central Bank signaled that it will probably raise interest rates in July because of rising inflation. And this Tuesday, the central bank of Canada held interest rates steady, when it had been expected to cut. Again, inflation was the explanation.