2nd UPDATE:Bernanke: Commodity Drop Welcome,Inflation To Fall

Aug.22, 2008 in Market Outlook

JACKSON HOLE, Wyo. (Dow Jones)–Federal Reserve Chairman Ben Bernanke Friday
signaled he isn’t contemplating higher interest rates despite what he called a
“jump” in inflation, saying he expects those pressures to subside.

Bernanke also said officials “remain focused” on addressing risks to the economy
and financial markets which have led officials to maintain a “relatively low”
federal-funds rate target for interbank lending.

Officials are betting that stable commodity prices coupled with slower global
growth and anchored inflation expectations will eventually soften price
pressures, Bernanke said in opening remarks to the Kansas City Fed’s annual
Jackson Hole conference.

“In this regard, the recent decline in commodity prices, as well as the increased
stability of the dollar, has been encouraging,” Bernanke said.

“If not reversed, these developments, together with a pace of growth that is
likely to fall short of potential for a time, should lead inflation to moderate
later this year and next year,” Bernanke said, though he called the price outlook
“highly uncertain” and said officials “will act as necessary” to make sure prices
moderate.

Still, Bernanke’s upbeat outlook for inflation - despite a recent jump in
inflation to a 17-year high annual rate of 5.6% as measured by the consumer price
index - supports Wall Street expectations that the Fed will hold the target
fed-funds rate unchanged at 2% into 2009.

But that’s an uncomfortable pause, as the Fed faces pressures on growth,
inflation and financial markets. Indeed, Bernanke called the current economic and
policy environment “one of the most challenging…in memory.”

At last year’s Jackson Hole event, which focused on housing, the fed-funds rate
stood much higher, at 5.25%. But the Fed embarked on a massive fed-funds easing
campaign weeks after that conference, slashing the rate 3.25 percentage points
between September and April before holding it steady the past two policy
meetings.

This year’s two-day conference focuses on financial stability, and the bulk of
Bernanke’s prepared remarks addressed market conditions and the regulatory reform
outlook.

“Although we have seen improved functioning in some markets, the financial storm
that reached gale force some weeks before our last meeting (in Jackson Hole in
August 2007) has not yet subsided, and its effects on the broader economy are
becoming apparent in the form of softening economic activity and rising
unemployment,” Bernanke said.

Bernanke said officials need to consider ways to improve the financial
infrastructure. He outlined a series of options including better settlement of
credit-default swaps, improved management of triparty repos - perhaps through a
central counterparty - and a framework to deal with nonbank institutions in case
of default. The Treasury Department “seems an appropriate choice” to deal with
nonbank financial institution defaults, he said.

“In the longer term, we need to ensure that there are robust contingency plans
for managing, in an orderly manner, the default of a major participant” in
triparty repo markets, he said.

In addition, “we should critically examine capital regulations, provisioning
policies, and other rules applied to financial institutions to determine whether,
collectively, they increase the procyclicality of credit extension beyond the
point that is best for the system as a whole,” Bernanke said.

He also said regulators should consider stress testing a “range of firms and
markets simultaneously” as opposed to individual firms in order to better focus
on systemwide risks.

But Bernanke cautioned that any reform shouldn’t end up encouraging excessive
risk taking. “Mitigating that problem is one of the design challenges we face as
we consider the future evolution of our system,” Bernanke said.

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