Wednesday, February 14, 2007

Bernanke's Inflation Statement

From today's testimony:

I turn now to the inflation situation. As I noted earlier, there are some indications that inflation pressures are beginning to diminish. The monthly data are noisy, however, and it will consequently be some time before we can be confident that underlying inflation is moderating as anticipated.

Translation: The recent numbers have been down, but we don't know if the trend will continue.

Recent declines in overall inflation have primarily reflected lower prices for crude oil, which have fed through to the prices of gasoline, heating oil, and other energy products used by consumers.

Inflation's decrease is commodity specific. If oil goes up, we will have inflation problems again.

After moving higher in the first half of 2006, core consumer price inflation has also edged lower recently, reflecting a relatively broad-based deceleration in the prices of core goods. That deceleration is probably also due to some extent to lower energy prices which have reduced costs of production and thereby lessened one source of pressure on the prices of final goods and services.

Oil rears its ugly head again.

The ebbing of core inflation has likely been promoted as well by the stability of inflation expectations.

People aren't freaking out about inflation.

A waning of the temporary factors that boosted inflation in recent years will probably help foster a continued edging down of core inflation. In particular, futures quotes imply that oil prices are expected to remain well below last year's peak. If actual prices follow the path currently indicated by futures prices, inflation pressures would be reduced further as the benefits of the decline in oil prices from last year's high levels are passed through to a broader range of core goods and services. Nonfuel import prices may also put less pressure on core inflation, particularly if price increases for some other commodities, such as metals, slow from last year's rapid rates.

Right now, the trend in oil prices is down. That's good.

But as we have been reminded only too well in recent years, the prices of oil and other commodities are notoriously difficult to predict, and they remain a key source of uncertainty to the inflation outlook.

Remember -- we're talking about oil.

The contribution from rents and shelter costs should also fall back, following a step-up last year. The faster pace of rent increases last year may have been attributable in part to the reduced affordability of owner-occupied housing, which led to a greater demand for rental housing. Rents should rise somewhat less quickly this year and next, reflecting recovering demand for owner-occupied housing as well as increases in the supply of rental units, but the extent and pace of that adjustment is not yet clear.

Here, Bernanke is talking about owner's equivalent rent, which is used in calculating the official inflation rate. Instead of using the actual price of a house, the Bureau of Labor Statistics uses OER, hoping to get a measurement of the investment value of the home. Yes, this is an economic way of saying, "we're basically rigging the number with a heavily downward bias, especially in an overbuilt real estate market."

Upward pressure on inflation could materialize if final demand were to exceed the underlying productive capacity of the economy for a sustained period. The rate of resource utilization is high, as can be seen in rates of capacity utilization above their long-term average and, most evidently, in the tightness of the labor market. Indeed, anecdotal reports suggest that businesses are having difficulty recruiting well-qualified workers in certain occupations. Measures of labor compensation, though still growing at a moderate pace, have shown some signs of acceleration over the past year, likely in part the result of tight labor market conditions.

Econ 101: when demand is greater than supply, prices increase.

The implications for inflation of faster growth in nominal labor compensation depend on several factors. Increases in compensation might be offset by higher labor productivity or absorbed by a narrowing of firms' profit margins rather than passed on to consumers in the form of higher prices; in these circumstances, gains in nominal compensation would translate into gains in real compensation as well. Underlying productivity trends appear favorable, and the markup of prices over unit labor costs is high by historical standards, so such an outcome is certainly possible. Moreover, if activity expands over the next year or so at the moderate pace anticipated by the FOMC, pressures in both labor and product markets should ease modestly. That said, the possibility remains that tightness in product markets could allow firms to pass higher labor costs through to prices, adding to inflation and effectively nullifying the purchasing power of at least some portion of the increase in labor compensation. Thus, the high level of resource utilization remains an important upside risk to continued progress on inflation.

If companies start raising prices to make-up for an increase in wages, we could have more inflation.

Monetary policy affects spending and inflation with long and variable lags. Consequently, policy decisions must be based on an assessment of medium-term economic prospects. At the same time, because economic forecasting is an uncertain enterprise, policymakers must be prepared to respond flexibly to developments in the economy when those developments lead to a re-assessment of the outlook. The dependence of monetary policy actions on a broad range of incoming information complicates the public's attempts to understand and anticipate policy decisions.

This whole thing could change at a moments notice.

Personally, I don't think this is a very bullish statement. It seems like Bernanke is saying the same thing he always says. The Fed is data dependent. Things can change. Oil's a huge wild card.

Obviously, the market thinks differently. And the market's actual reaction is more important than in individual's interpretation.