Wednesday, July 18, 2007

What to Listen for in Bernanke’s Testimony Today

No doubt today’s testimony by Ben Bernanke before Congress will focus on his views on inflation, including the debate re headline versus core inflation. A careful reading of his speech of last week provides the answer. Based on his comments, the debate of headline versus core inflation appears to be quite resolved in the Fed chairman’s mind. Here are a few observations:

For Ben Bernanke, it is core inflation that matters most. To the extent that headline inflation comes into the mix, his comments re the sustainability of “changes in oil prices and other supply shocks” are not likely to effect the public’s expectations of inflation as the data shows that their expectations are “anchored”, meaning that the public’s inflationary expectations are “relatively insensitive to incoming data”. This view is significant in that Bernanke apparently believes that, to the extent that components in headline inflation are impacted by supply shocks, the likelihood that they will result in a more serious and sustainable rise in core inflation are limited.

For example, in referring to research on anchoring, Bernanke notes, “Changes in the trend component are highly persistent whereas shocks to the cyclical component are temporary”. He, therefore, goes on to note that “unexpected changes in inflation are today much more likely to be transitory than they were before the early 1980s”.

There is one important additional factor to note re his comments of last week that is quite telling. While data, research studies, and econometric models may point to a conclusion, it is judgment, by him, his fellow Governors, and the Fed staff, that is the most crucial component in the Fed’s decision process. In other words, the Bernanke Fed is not dogmatic in either its process or views.

Investment Strategy Implications

The subject of Bernanke’s speech last week was “Inflation Expectations and Inflation Forecasting”. It could have just as easily been titled “Why I Believe Core Inflation Matters Most”. Therefore, I am fairly certain that his comments today will reinforce that view. If so, one might assume that, with core inflation moderating of late, interest rate increases are not likely. This would be a mistake. For while the subject of last week’s speech dealt with inflation expectations and behavioral science issues like anchoring, the unmistakable gist of both last week’s speech and other comments by the chairman and other key members of the Fed is that judgment is central to the Fed’s monetary decision-making process. Therefore, when it comes to this Fed, all the talk about inflation targeting is nonsense.

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