2.5% -- Here we come!

Talk about a buzz-kill…yesterday, Federal Reserve Chairman Ben Bernanke delivered an economic forecast before the House Financial Services Committee that sounded about as downbeat as we have heard since the depths of the 2001-02 economic retrenchment. But you have to love the “silver lining of every cloud” aspect of investors: you can tell them that the world is falling apart and stocks can still hang in there.

Here are some excerpts of Bernanke’s testimony: “The economic situation has become distinctly less favorable since the time of our July report. Strains in financial markets, which first became evident late last summer, have persisted; and pressures on bank capital and the continued poor functioning of markets for securitized credit have led to tighter credit conditions for many households and businesses…The housing market is expected to continue to weigh on economic activity in coming quarters. Homebuilders, still faced with abnormally high inventories of unsold homes, are likely to cut the pace of their building activity further, which will subtract from overall growth and reduce employment in residential construction and closely related industries…

The jump in the price of imported energy, which eroded real incomes and wages, likely contributed to the slowdown in [consumer] spending, as did the declines in household wealth associated with the weakness in house prices and equity prices. Slowing job creation is yet another potential drag on household spending, as gains in payroll employment averaged little more than 40,000 per month during the three months ending in January, compared with an average increase of almost 100,000 per month over the previous three months.”

The preceding reminds of one of my favorite sayings from a real estate mogul that I know: we like good news too! Well, there was not much good news in Bernanke’s downbeat assessment, yet stocks held firm as he testified. The reason is fairly simple: when the Fed chief says that he is more concerned about slowing growth than inflation, investors actually hear “WE’RE LOWERING INTEREST RATES AT THE NEXT FOMC MEETING IN MARCH!” It is now widely believed that the Fed will drop rates by ½ point at that meeting, which would mean that Fed Funds would be at 2.5%.

Yet with oil over $100 and agricultural commodities soaring (spring wheat is up 90% year-to-date, while soybeans, corn and rice are all up 50-60% since last summer), Mr. Bernanke hedged a bit on the inflation outlook. Clearly prices have increased (see yesterday’s article) and despite Bernanke’s assertion that “inflation could be lower than we anticipate if slower-than-expected global growth moderates the pressure on the prices of energy and other commodities or if rates of domestic resource utilization fall more than we currently expect,” he also was forced to acknowledge that recent data “suggest slightly greater upside risks to the projections of both overall and core inflation than we saw last month.” Investors seemed content to focus on the cuts, rather than the potential inflationary pressures…at least for now.

Investors probably heard correctly when they took in BB’s testimony: in order to forestall a potentially massive debt-unwinding event, the Fed has decided to abandon the inflation fighting half of its dual mandate. The consequences of these actions are likely to reverberate for some time. As we anxiously await 2.5%, potentially on our way to 2%, I can’t help but think that the credit crisis we are in right now is the result of the Fed’s previous reflation strategy from 2001-2004. But that’s a topic for another article.