The US Federal Reserve expects inflation to retreat from recent highs but could still raise interest rates, Ben Bernanke, chairman, told Congress yesterday.
His testimony, which gave a strong boost to US and European share prices and Treasury bonds, came as the Fed released forecasts suggesting that it is prepared to bring US inflation down gradually, to minimise the damage to the economy.
The forecasts to congress show Fed policymakers are willing to tolerate an inflation rate, on its core measure, of 2 per cent or slightly above this year and next, providing it is heading in the right direction.
The Fed officials think that this approach will allow the economy to grow at close to its trend rate over this year and next.
Financial markets, which had earlier been unnerved by data showing core consumer prices rose 0.3 per cent in June, responded enthusiastically to the news.
The S&P 500 index was up in New York yesterday by 22.94 points, or 1.85 per cent, to 1,259.80, pushing it back into positive territory for the year to date. The 30-year bond also rose 30/32 in price for a yield of 5.10 per cent compared with 5.17 per cent on Tuesday.
Mr Bernanke told senators: "Our baseline forecast is for moderating inflation."
This forecast is based on the assumption that a slowdown from above-trend growth is already under way and "should help to limit inflation pressures over time".
Mr Bernanke also noted that the futures market suggested the price of oil would stabilise and that profit margins were fat enough to absorb some acceleration in wage increases.
But the Fed chairman said "some inflation risks remain". He said the combination of high energy prices and high levels of capacity utilisation "have the potential to sustain inflationary pressures".
Mr Bernanke noted the potential for recent inflation surprises to become embedded in expectations and warned that this would be "costly to reverse".
Laying out the Fed's risk management approach, Mr Bernanke said: "We must consider not only what appears to be the most likely outcome but also the risks to that outlook, and the costs that would be realised should any of those risks be realised".
This suggests that the Fed may be prepared to raise rates again even though its baseline forecast is reassuring.
The forecasts in the Economic Report to Congress, which reflect the "central tendency" of estimates provided by individual Fed policymakers, show they now see growth of 3.25-3.5 per cent this year, and 3-3.25 per cent next year, slightly lower than they did in February.
They nudged higher their estimates of core inflation, measured by the personal consumption expenditure deflator, to 2.25-2.5 per cent this year and 2-2.25 per cent next.
The dollar hit a three-month highs against the euro yesterday after the inflation figures, reinforcing the likelihood that the European Central Bank (ECB) will raise interest rates on August 3rd as expected. The weaker euro will tend to strengthen the impact of increasing oil prices, which are dollar denominated, on euro-zone inflation.
