Fed Chairman Ben Bernanke is testifying before the House today in his semi-annual Humphrey Hawkins appearance. Below are his prepared remarks on the state of the economy, along with my commentary and translation.

“Following the stabilization of economic activity in mid-2009, the U.S. economy is now in its seventh quarter of growth; last quarter, for the first time in this expansion, our nation’s real gross domestic product (GDP) matched its pre-crisis peak. Nevertheless, job growth remains relatively weak and the unemployment rate is still high.”
 
In other words, most of the growth has come from higher productivity, not more hours being worked.  We are producing the same amount of output of goods and services (in real terms) as we were before the recession but are doing so with about 7.5 million fewer workers.

“In its early stages, the economic recovery was largely attributable to the stabilization of the financial system, the effects of expansionary monetary and fiscal policies and a strong boost to production from businesses rebuilding their depleted inventories. Economic growth slowed significantly in the spring and early summer of 2010, as the impetus from inventory building and fiscal stimulus diminished and as Europe’s debt problems roiled global financial markets.

“More recently, however, we have seen increased evidence that a self-sustaining recovery in consumer and business spending may be taking hold. Notably, real consumer spending has grown at a solid pace since last fall, and business investment in new equipment and software has continued to expand. Stronger demand, both domestic and foreign, has supported steady gains in U.S. manufacturing output.”

Stimulative policies — both fiscal and monetary — have been key elements of boosting demand, and with it the overall economy. The inventory bounce is over, and inventories turned into a massive drag on the economy in the fourth quarter, subtracting 3.7 points from growth.

That is a huge turnaround from earlier in the year. Inventory rebuilding added 1.61 points to growth in the third quarter and 0.82 in the second quarter. With the inventory effect, economic growth was 2.8% in the fourth quarter, 2.6% in the third and 1.7% in the second. If the inventory effect were excluded, we would have seen growth of 6.9% in the fourth quarter, but only 1.0% in the third and 0.9 in the second quarter.

“The combination of rising household and business confidence, accommodative monetary policy and improving credit conditions seems likely to lead to a somewhat more rapid pace of economic recovery in 2011 than we saw last year. The most recent economic projections by Federal Reserve Board members and Reserve Bank presidents, prepared in conjunction with the Federal Open Market Committee (FOMC) meeting in late January, are for real GDP to increase 3-1/2 to 4 percent in 2011, about one-half percentage point higher than our projections made in November. Private forecasters’ projections for 2011 are broadly consistent with those of the FOMC participants and have also moved up in recent months.”
 
In normal times, that would be very robust growth, but for coming out of a very deep downturn it is still on the anemic side. Then again, historical and international data show that recoveries from financial panic caused recessions tends to be much slower than from recessions caused by either the inventory cycle or “deliberate recessions” caused when the central bank tightens monetary policy to choke off excessively high inflation.

“While indicators of spending and production have been encouraging on balance, the job market has improved only slowly. Following the loss of about 8-3/4 million jobs from early 2008 through 2009, private-sector employment expanded by only a little more than 1 million during 2010, a gain barely sufficient to accommodate the inflow of recent graduates and other entrants to the labor force.

“We do see some grounds for optimism about the job market over the next few quarters, including notable declines in the unemployment rate in December and January, a drop in new claims for unemployment insurance, and an improvement in firms’ hiring plans. Even so, if the rate of economic growth remains moderate, as projected, it could be several years before the unemployment rate has returned to a more normal level.

“Indeed, FOMC participants generally see the unemployment rate still in the range of 7-1/2 to 8 percent at the end of 2012. Until we see a sustained period of stronger job creation, we cannot consider the recovery to be truly established.”

Some of those grounds for optimism include initial claims for unemployment benefits breaking out of the “trading range” they were stuck in for most of 2010 to the downside, and the ISM manufacturing employment sub-index which was released today and is at its highest level since January of 1973. Without a doubt, though, employment has come back much more slowly than GDP or corporate profits.

There is still a huge amount of slack in the system, and there seems to be little political appetite to do anything about the high level of unemployment. The focus has turned to cutting spending, with an emphasis not on restraining the long-term structural deficit, but chopping spending in the short term. This is likely to slow the economy and further slow job growth.

For example, Mark Zandi of Moody’s Economics and a top economic advisor to the McCain campaign, has estimated that if the $61 billion in spending cuts for the rest of the year recently passed by the House were to become law, it would cut employment by a total of 700,000 jobs over 2001 and 2012.  (see here).

“Likewise, the housing sector remains exceptionally weak. The overhang of vacant and foreclosed houses is still weighing heavily on prices of new and existing homes, and sales and construction of new single-family homes remain depressed. Although mortgage rates are low and house prices have reached more affordable levels, many potential homebuyers are still finding mortgages difficult to obtain and remain concerned about possible further declines in home values.”

This is the key reason why the recovery has been so anemic. In a normal recovery, it is housing that leads the way, not a part of the economy that acts as an anchor. New home sales, and thus new home construction, are much more important to overall economic activity than are used home sales. Used home sales are important only relative to the amount of inventory, since that shows which direction home prices are likely to head.

Home prices are vitally important. Foreclosures simply do not occur when the homeowner has positive equity in his house, and falling home prices mean that more and more people will be pushed underwater, and thus at risk of foreclosure. Also, home equity is by far the most important store of wealth for the middle class. Stock market wealth is much more concentrated at the top of the economic pyramid than is housing wealth.

The decline in home values has devastated the balance sheets of millions and millions of households. To repair them, they have to save the old fashioned way — by spending less than they earn. A rising savings rate, while desirable in the long term, slows the rate of economic growth.

“Inflation has declined, on balance, since the onset of the financial crisis, reflecting high levels of resource slack and stable longer-term inflation expectations. Indeed, over the 12 months ending in January, prices for all of the goods and services consumed by households (as measured by the price index for personal consumption expenditures [PCE]) increased by only 1.2 percent, down from 2.5 percent in the year-earlier period.

“Wage growth has slowed as well, with average hourly earnings increasing only 1.9 percent over the year ending in January. In combination with productivity increases, slow wage growth has implied very tight restraint on labor costs per unit of output.

“FOMC participants see inflation remaining low; most project that overall inflation will be about 1-1/4 to 1-3/4 percent this year and in the range of 1 to 2 percent next year and in 2013. Private-sector forecasters generally also anticipate subdued inflation over the next few years.

“Measures of medium- and long-term inflation compensation derived from inflation-indexed Treasury bonds appear broadly consistent with these forecasts. Surveys of households suggest that the public’s longer-term inflation expectations also remain stable.

“Although overall inflation is low, since summer we have seen significant increases in some highly visible prices, including those of gasoline and other commodities. Notably, in the past few weeks, concerns about unrest in the Middle East and North Africa and the possible effects on global oil supplies have led oil and gasoline prices to rise further.

“More broadly, the increases in commodity prices in recent months have largely reflected rising global demand for raw materials, particularly in some fast-growing emerging market economies, coupled with constraints on global supply in some cases. Commodity prices have risen significantly in terms of all major currencies, suggesting that changes in the foreign exchange value of the dollar are unlikely to have been an important driver of the increases seen in recent months.”

Inflation, particularly core inflation, is not a problem. There have been those who have been screaming that high inflation was just around the corner since the start of the financial crisis. They have been dead wrong so far and are likely to remain so.

Yes, oil prices have been on the rise, as have food prices, but they make up a small part of overall consumer spending in the U.S. That is not as true elsewhere in the world. There is a huge amount of slack in the economy, as evidenced by a 9.0% unemployment rate and an overall capacity utilization rate of just 76.1% (versus a long-term average rate of 80.5%).

Growth that comes from absorbing excess slack is not likely to be inflationary, so the economy could surge for several quarters before it started to overheat. It is almost impossible to get a wage price spiral going with an unemployment rate this high. If a worker demands higher wages, he is likely to find himself with no wages at all.

While Bernanke is correct that commodity prices have been rising in terms of all major currencies, they have been rising more in dollar terms than in Euro or yen terms as the dollar has weakened. The bond market clearly does not see high inflation coming anytime soon. If it did, there would be no way that people would willingly lock up their money for 10 years for less than 3.5%. Ignore the inflation fearmongers.

“The rate of pass-through from commodity price increases to broad indexes of U.S. consumer prices has been quite low in recent decades, partly reflecting the relatively small weight of materials inputs in total production costs as well as the stability of longer-term inflation expectations. Currently, the cost pressures from higher commodity prices are also being offset by the stability in unit labor costs.

“Thus, the most likely outcome is that the recent rise in commodity prices will lead to, at most, a temporary and relatively modest increase in U.S. consumer price inflation — an outlook consistent with the projections of both FOMC participants and most private forecasters.

“That said, sustained rises in the prices of oil or other commodities would represent a threat both to economic growth and to overall price stability, particularly if they were to cause inflation expectations to become less well anchored. We will continue to monitor these developments closely and are prepared to respond as necessary to best support the ongoing recovery in a context of price stability.”

Overall, this testimony is broadly consistent with what the Fed has been saying for months now: the economy is recovering, but at a relatively mediocre pace, one that has not been fast enough to really spur a lot of job creation. Inflation has not been — and should not be — a problem. The recovery, while starting to gain traction, remains fragile.

The instability in the Middle East, and resulting increase in oil prices, is one of the things that could knock it off track. I would also say that a shift to a very contractionary fiscal policy, at both the Federal as well as the State and Local levels also poses a significant risk to the recovery. While we need to get a handle on the long-term structural deficit, trying to bring it down too fast right now risks slowing the recovery significantly.

The key to containing the structural deficit is to lower the rate of increase in health care costs. Spending cuts now that result in lower economic growth will slow the recovery in tax revenues, and the net result is that the reduction in the deficit from the cuts will be far less than advertised.
 
Zacks Investment Research