Dr Bernanke had been expected to pull out all the stops in an eagerly awaited speech to the Economics Club in Washington DC. The leitmotif was intended to be personal savings…or the lack thereof and thus, by extension a clear line on the Fed’s thinking regarding the collapse in the residential property market. In previous commentary Dr Bernanke has linked comment pertaining to the savings ratio to concern regarding the current account and budget deficits.
On the basis that weakening energy prices are set to close the current account deficit somewhat over the months ahead this speech really did hold out the possibility that the Fed Chairman might pin his concerns elsewhere namely; a need to rebuild the savings ratio from negative territory in the context of slowing growth in residential property investment, falling mortgage equity withdrawal, a slowing in consumption growth and possible negative wealth effect from falling house prices. Dovish or what?
Bernanke: Don’t worry, be happy
Well none of the above really. Wishful thinking on our part perhaps given that the Fed does, of course, retain a de facto tightening bias to policy right now. Dr Bernanke certainly did refer to a “substantial correction” in US property prices of late and that the decline in residential construction would, alone, subtract c1% point from overall GDP growth over the second half of 2006 and the first half of 2007, but balanced the comment by indicating that the impact of falling house prices had barely impacted other areas of the economy yet. Furthermore, Dr Bernanke pointed to strong underlying fundamentals (low levels of unemployment, rising wages and demographic changes) as possible justification for the decline in house prices being manageable and perhaps short-lived.
As if to impart balance and to justify the Fed’s decision to maintain its tightening bias Dr Bernanke discussed the outlook for inflation which, he suspects, may only recede slowly. Nevertheless the financial markets are buying into the “soft landing” story very aggressively and equity prices have really got the bit between their teeth. Irrespective of Dr Bernanke’s tempering remarks the Fed Funds futures contract jolted into life in the wake of his comments and now factors in a high (82%) probability of a rate cut at the March 21st FOMC meeting in the wake of a 36% chance of a rate cut in January.
After the reflation trade ‘sugar burst’, what next?
Judging by bond and equity market pricing financial market investors are buying aggressively into the soft landing scenario (i.e. the Fed will begin the process of rate reductions before the probability of a “hard landing” rises above 50%, currently 40%). This conclusion is also Charles Stanley’s central projection too although it has been noted in this column already and by other commentators too (including, according to the FT, the former US Treasury Secretary Mr Robert Rubin) that the financial markets are not always the most accurate lead indicators of future economic activity. This raises the possibility that, once the energy derived from the reflation trade “sugar burst” wears off investors might be left pondering the reasons why the Fed felt it necessary to discuss the impact of the weakening property market in the first place.
By Jeremy Batstone, Director of Private Client Research at Charles Stanley