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Why Fed Expects Growth to Slow

The Federal Reserve's balancing act between weakening growth and rising prices is getting tougher. Fed Chairman Ben Bernanke said that since the Fed reduced short-term interest rates a quarter of a percentage point to 4.5% a week ago, concerns about credit-market strains have intensified while rising oil prices threaten to fuel inflation and put "further restraint on economic activity."

Mr. Bernanke's testimony to the Joint Economic Committee of Congress yesterday echoed the Fed's statement last week that it saw the risks of economic weakness and higher inflation as roughly balanced, a signal it thought no more rate cuts would be needed.

Since then, stocks have sunk on worries about the prospect of bigger mortgage-related write-offs by banks and other financial institutions. That has renewed expectations the Fed will cut rates, perhaps as soon as its Dec. 11 meeting. That expectation has contributed to a weakening of the dollar, which tends to fall when U.S. interest rates decline while foreign rates are steady or rising, and put upward pressure on oil, gold and other commodity prices.

Whether the Fed does decide to cut rates depends on if it agrees with the market's forecast that financial turmoil means the economy will be even weaker than the Fed's already subdued forecast.

Data since last week's meeting still "suggest that the overall economy remained resilient in recent months," Mr. Bernanke said. The third-quarter annualized gross domestic product growth rate of about 4% showed "scant evidence of spillovers from housing" to the broader economy.

He said the Fed's policy committee sees growth slowing "noticeably" in the current quarter and remaining "sluggish during the first part of next year" but "then strengthening as the effects of tighter credit and the housing correction began to wane."

Mr. Bernanke played down the threat to consumers' spending from their decreased ability to borrow against home values, citing the greater importance of overall wealth, which hasn't declined. Moreover, he added, "to the extent labor markets remain reasonably strong and employment and income continue to grow, that's a positive." Adding evidence to that case, the Labor Department said yesterday that the number of initial claims for unemployment insurance fell 13,000 last week to 317,000, the lowest level in a month.

Still, the Fed chief also said that "financial market volatility and strains have persisted" and that investor concerns have "intensified...about credit market developments and the implications of the downturn in the housing market for economic growth." He predicted that over the next year, 450,000 subprime mortgages each quarter will see interest rates reset, boosting monthly mortgage payments. A resulting jump in foreclosures could drive down surrounding property values, "weaken the already struggling housing market and thus, potentially, the broader economy."

REAL TIME ECONOMICS

 

• Read the latest news and analysis on the economy at WSJ.com's Real Time Economics blog.

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Underscoring the delicacy of current circumstances, Mr. Bernanke acknowledged inflation risks from oil as well as the weaker dollar, saying the Fed is "very attentive" to the risk that the falling dollar has "the potential to raise import prices and contribute to inflation."

Sen. Sam Brownback, a Kansas Republican, told Mr. Bernanke that he was "delighted you're in that job and I'm not."

Write to Greg Ip at greg.ip@wsj.com

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