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Fed Chief Raises Inflation Concern
Stocks Fall on Prospect of Higher Rates

By Nell Henderson and Brooke A. Masters
Washington Post Staff Writers
Tuesday, June 6, 2006

Federal Reserve Chairman Ben S. Bernanke expressed more concern about rising inflation than the cooling U.S. economy yesterday, sending his strongest signal yet that interest rates are probably headed higher.

Stocks plunged after Bernanke vowed to combat the recent "unwelcome" pickup in inflation, even as he told an international bankers' conference that an economic slowdown "seems now to be underway."

The combination of high inflation and sluggish growth causes pain throughout an economy: Rising prices reduce the purchasing power of workers' wages, erode savings and diminish the returns on investment. Slow growth pushes up unemployment, squeezes corporate profit and discourages businesses from expanding.

Like many economists, Bernanke argues that keeping inflation low is vital to promoting a strong economy because it allows people to make purchases, borrow money, plan for retirement, invest and make other financial decisions without worrying about rising prices. But beating inflation means raising interest rates, which crimps consumer spending by raising borrowing costs.

"He came right out and said we're worried about inflation," said Arthur Hogan, chief market analyst at Jefferies & Co. "Just what the market didn't need to hear."

Major U.S. stock market indicators fell about 2 percent on the day as Bernanke's comments deflated hopes that the Fed was near the end of two years of steady interest rate increases.

After taking over as Fed chief in February, Bernanke's first public speech was on the importance of low inflation, or "price stability" in central bank jargon. Yet many analysts and investors in financial markets questioned his inflation-fighting credentials in recent weeks, particularly after he told Congress in late April that the Fed might leave interest rates unchanged at an upcoming meeting even if there were risks of higher inflation.

Bernanke's comments yesterday left much less doubt. "He laid down a marker -- that inflation is the primary issue" for the Fed, said David Shulman, a senior economist with the UCLA Anderson Forecast produced by the University of California at Los Angeles Anderson School of Management.

Consumer price inflation has risen this year, largely because of climbing energy prices, Bernanke said. Moreover, he added, measures of "core" inflation, which exclude traditionally volatile food and energy prices, have also moved higher in recent months. The Labor Department's core consumer price index rose at a 3.2 percent annual rate over the past three months and at a 2.8 percent pace over the past six months, he said.

"These are unwelcome developments," Bernanke said, deflating financial market hopes that the central bank would soon stop raising interest rates. Fed officials "will be vigilant to ensure that the recent pattern of elevated monthly core inflation readings is not sustained."

Many analysts forecast the economy to slow as the housing market cools and dampens consumer spending, which would cause employers to pull back on hiring. That process has begun, Bernanke said.

Still, he did not sound too worried about the economy's health, noting other sources of strength in rising U.S. exports, increased business investment, low unemployment and generally healthy consumer finances.

Fed economists have expected consumer prices to rise temporarily this year, as businesses pass on some of their higher costs for energy, metals and other raw materials. But Bernanke expressed concern that inflation might persist at an unacceptably high level, particularly if it causes businesses and consumers to expect bigger price increases.

Fed policymakers "must continue to resist any tendency for increases in energy and commodity prices to become permanently embedded in core inflation," Bernanke said.

Before his warning, many investors believed there was a 50-50 chance the Fed might leave its benchmark short-term rate unchanged at its policymaking meeting June 28-29, taking a pause after two years of steady increases. After his remarks, futures markets traders boosted their bets that Fed officials will increase the rate to at least 5.25 percent from 5 percent, for a 17th consecutive increase.

"The markets see [interest] rates going up and staying high for a while," while the economy slows and profits get squeezed, Shulman said.

The Standard & Poor's 500-stock index fell 1.8 percent, its steepest one-day drop since January. The Dow Jones industrial average dropped 1.8 percent, to its lowest level since early March. The Nasdaq composite index shed 2.2 percent, erasing any gain this year. Meanwhile, oil closed at more than $72 a barrel yesterday after Iran's leader threatened to reduce production in response to Western pressure to curtail that nation's nuclear technology program.

Global financial markets have been volatile for more than a month, largely because of uncertainty about inflation, interest rates, oil prices and the pace of U.S. economic growth.

The markets' reaction yesterday reversed the gains recorded Friday, when a weak labor-market report encouraged many investors to think the Fed would not raise interest rates this month for fear of "overshooting," or raising rates too high and triggering a sharper economic slump.

But, Bernanke said, a single economic report, such as one month's employment figures, would not by itself change the Fed's interest rate policy. Rather, because interest rate changes take effect over many months, the Fed would study how such a report affects its forecast for the economy six to 12 months down the road.

"He seemed to have greater concern for inflation than a slowing economy," said Stephen Massoca, co-chief executive of the boutique investment bank Pacific Growth Equities LLC.

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