Stocks Rise as Bernanke Hints That Fed May Pause Rate Increases

Federal Reserve Board Chairman Ben Bernanke delivers the board's Monetary Policy Report to the Senate Banking Committee in Washington Wednesday, July 19, 2006. Bernanke told Congress on Wednesday that record high oil prices are a concern, but that a slowing economy should moderate inflation down the road. (AP Photo/Dennis Cook) (Dennis Cook - AP)

The biggest threat to the economy, Bernanke said twice in response to questions, would be for inflation to flare higher than expected. That would force the Fed to raise interest rates more aggressively, boosting the risk of a recession, he said.

Among the reasons to worry, he said, are rising oil prices, which have more than doubled from less than $30 a barrel in 2003 to above $70 today. Strengthening global growth and persistent geopolitical tensions threaten to drive the prices of oil and other raw materials still higher, he said.

Fed policymakers also worry that higher prices might cause consumers and businesses to expect them to keep rising, with inflation thus becoming a self-fulfilling prophecy.

The Fed does expect U.S. economic growth to slow modestly from its rapid pace of the past three years to a solid rate just above 3 percent next year. And that, Bernanke said, "should help to limit inflation pressures over time."

But he also emphasized that forecasts can be wrong and said the Fed would continue to use former chairman Alan Greenspan's "risk management" approach to interest-rate policy. That means basing policy not only on the most likely outcome, but also guarding against results that might be less probable but more harmful.

The Greenspan Fed, for example, lowered its benchmark rate to 1 percent in 2003 to guard against the possibility of deflation -- an economically destructive decline in the overall price level.

Today, the Bernanke Fed's comparable worry is that inflation might take off. The debate within the Fed is whether higher interest rates will be needed to slow the economy enough to prevent that from happening.

Some senators suggested the Fed has raised rates enough, and perhaps too much. "Inflation is not out of control," said Sen. Jim Bunning (R-Ky.), a frequent Fed critic. "The Fed is chasing an inflation monster that is just not there."

Bernanke said the Fed does not want to raise rates so high as to choke growth, but he appeared to play down that danger by saying he did not "see a recession as being very likely."

The Fed policymakers' forecast of inflation next year shows that they are "not willing to take rates to a point that would reduce inflation immediately but raise the risk of recession," said Mickey Levy, chief economist at Bank of America Corp. Rather, they are willing to tolerate inflation above 2 percent temporarily if it is drifting lower, and if inflation expectations are under control, he said.

Despite many investors' hopes for an August pause, Levy is among the analysts who predict the Fed will raise its benchmark short-term rate again at the next meeting, by another quarter of a percentage point, to 5.5 percent.

"While the markets rallied significantly," he said, "the Fed left open the possibility of raising rates as deemed appropriate."