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Ben Bernanke's Outlook for the Economy

A few quick reactions to Ben Bernanke's speech today where he talks about something of concern recently--namely, how the Fed will view changes in the value of the dollar. If the dollar begins to fall, that will increase the price of imported goods and materials used in production and that, in turn, adds to domestic inflationary pressure. To support the dollar and lower the inflation pressure, the Fed would have to raise interest rates, but that would endanger the recovery of domestic output and employment by raising borrowing costs, and it would also make U.S. exports more expensive to foreign buyers.

So, if the dollar starts falling, will the Fed raise interest rates to head off the inflationary pressure, or will it maintain low interest rates in an attempt to stimulate the economy? Bernanke says they will certainly keep an eye on the dollar, but it's only one part of a larger picture:

We are attentive to the implications of changes in the value of the dollar and will continue to formulate policy to guard against risks to our dual mandate to foster both maximum employment and price stability. Our commitment to our dual objectives, together with the underlying strengths of the U.S. economy, will help ensure that the dollar is strong and a source of global financial stability.

So what will the Fed do? Bernanke made it clear that while he sees some improvement, we are very far from the "all clear" sign for the economy:

On the one hand, those who see further weakness or even a relapse into recession next year point out that some of the sources of the recent pickup--including a reduced pace of inventory liquidation and limited-time policies such as the "cash for clunkers" program--are likely to provide only temporary support to the economy. On the other hand, those who are more optimistic point to indications of more fundamental improvements, including strengthening consumer spending outside of autos, a nascent recovery in home construction, continued stabilization in financial conditions, and stronger growth abroad.

My own view is that the recent pickup reflects more than purely temporary factors and that continued growth next year is likely. However, some important headwinds--in particular, constrained bank lending and a weak job market--likely will prevent the expansion from being as robust as we would hope.

He also made it clear that inflation is not much of a worry right now:

The outlook for inflation is also subject to a number of crosscurrents. Many factors affect inflation, including slack in resource utilization, inflation expectations, exchange rates, and the prices of oil and other commodities. Although resource slack cannot be measured precisely, it certainly is high, and it is showing through to underlying wage and price trends. Longer-run inflation expectations are stable, having responded relatively little either to downward or upward pressures on inflation; expectations can be early warnings of actual inflation, however, and must be monitored carefully. Commodities prices have risen lately, likely reflecting the pickup in global economic activity, especially in resource-intensive emerging market economies, and the recent depreciation of the dollar. On net, notwithstanding significant crosscurrents, inflation seems likely to remain subdued for some time.

Putting those two things together, fear that the economy will not recover as robustly as we'd like, plus the belief that inflation pressures are not a worry right now, leads to the following policy:

The Federal Open Market Committee continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

I agree (very much) that inflation is not a worry right now, and that the Fed should be primarily concerned with output and employment at this point. Today's remarks were intended to reassure markets (and foreigners holding our debt) that the dollar is on the Fed's radar, and that it won't allow the dollar to go into free fall. But practically, today's remarks tell us that the Fed expects to maintain low interest rates for the foreseeable future.

(For more on this topic, see Paul Krugman's The madness of the inflation hawks. And for a more wonkish take on current policy, let me recommend Tim Duy's latest Fed Watch.)

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