On Tuesday, in his semi-annual testimony to Congress, Ben Bernanke presented the Federal Reserve’s new macroeconomic forecast. Growth in the second half of the year is expected to be lower than in the first half. Meanwhile, inflation is expected to average 4% in Q4 2008, compared with the 3.25% anticipated in April. The risks to growth and prices, that is mainly the falling housing market, weak labour market and soaring energy prices, have increased in tandem over the last three weeks. In particular, developing long-term inflation expectations call for greater vigilance by the central bank. The surge in commodity prices is starting to have an impact on the price and wage-setting process. However, Ben Bernanke signalled that the FOMC’s main preoccupation was to restore calm to financial markets. Bond markets rallied consequently, as they did not expect a monetary tightening before the end of this year anymore. In the meanwhile, the dollar weakened further against the euro which reached a record high at 1.6038.

Nonetheless, the President watered down his testimony to the House of Representatives on Wednesday after the publication of June consumer price index data. Inflation hit 5% last month, its highest level since May 1991 and up from 4.2% in May. Once again, energy prices (up 6.6% month on month), which contributed two thirds of the increase in the overall index, and food prices (0.8% m/m) were the main factors behind the surge. The cost of transport is also now rising rapidly (3.4% m/m in June, after 2.3% in May). Underlying inflation was limited to 3.4%, a slight increase compared with the previous month (3.3%). Furthermore, the 25 June FOMC minutes, issued the same day, showed the monetary policy committee’s concerns. In particular, some members noted that there were increasing signs of inflation expectations rising. However, others believed that the rise was more significant in short-term household expectations, which were probably influenced by increasing food and gasoline prices. In this context, Ben Bernanke was compelled to declare that the current level of inflation was “too high”. This penalized the bond market while giving a boost to the dollar which strengthened to 1.5810 versus the euro.

The Fed Chairman was still concerned by an anticipated contraction of bank lending, as banks seek to stem losses and reduce exposure to risk. The US Treasury Secretary was presenting a rescue plan for Fannie Mae and Freddie Mac, the two mortgage refinancing companies, claiming that he was aiming not only to support these two financial institutions but also restore stability to the markets. The Treasury asked Congress to extend for eighteen months its powers to increase the credit line already granted to the two companies by the government ($12.25bn) and take an equity stake in them. In addition to changes to housing legislation, this plan requires approval from the Republicans, who are in favour of cleaning out the housing market and the main failing financial players.

Financial markets were still struggling to stabilise at the end of the week while the latest statistics and surveys showed that activity remains weak. In particular, the June recovery in industrial production (+0.5% m/m after -0.2% in May and -0.7% in April) was mainly due to the end of the strike at American Axle and a rise in electricity production following last month’s heatwave. As a result, it does not constitute the start of a change in trend, with regional surveys still consistent with declining activity in the US manufacturing sector.

As a result, we believe that the central bank is unlikely to raise interest rates in the immediate future unless there is significant slippage in inflation expectations.

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EcoFlash reflects the view of the Economic Research Department of BNP Paribas. It is published for information purposes only. Neither the information nor the opinion expressed constitutes an offer or solicitation to buy or sell any investments. Information contained herein has been obtained from sources believed to be reliable but BNP Paribas does not guarantee its accuracy or completeness. All opinions and forecasts are subject to change. Discretion with respect to suitability should be prudently exercised.