Ben Bernanke’s testimony to Congress, along with recent economic data, suggest that the Fed will raise rates one more time, to 5.5%, and then stop—at least for a while. Indeed, once Bernanke’s prepared comments were released at 10am yesterday, stocks and bonds rose and the dollar fell. The fed funds futures contracts swung dramatically, now indicating a much lower chance of further increases beyond 5.5%.
Many signs point to slower economic growth—smaller employment gains (though as Bernanke pointed out, changing demographics will be an important influence on future job gains), a slower housing market, elevated energy prices, the lagged effects of previous Fed moves, and central bank tightening in other countries. The Fed’s own forecast calls for more moderate growth and inflation. In short, Bernanke pointed out that even though we are at or near full employment, aggregate demand is expected to slow down. On the supply side, productivity growth (which Bernanke expects to persist) will also help contain inflation. And as I pointed out previously, as long as the Fed does not accommodate higher energy prices, these won’t have a long-term impact on inflation.
Still, he pointed out that business investment and foreign economic growth are strong, which could add somewhat to inflationary pressures. He also said that pricing power was allowing some firms to pass on higher energy costs. On the supply side, he suggested that a tight labor market could work to push up real wages. So, there are still some risks that could increase inflation. He finished his testimony by noting that forecasting is imperfect and subjective and that the Fed could tighten too much or not enough.
Based on all of this information, and the fact that the Fed tends to stop on round numbers, 5.5% should be it, at least for now. It seems that the downside risks outweigh the upside risks somewhat.