Correction to This Article
Earlier versions of the headline on this story incorrectly identified Rep. Barney Frank (D-Mass.) as a senator. This version has been corrected.

Bernanke Rebuffs Frank on Rate Cut

By Nell Henderson
Washington Post Staff Writer
Friday, February 16, 2007

Federal Reserve Chairman Ben S. Bernanke yesterday rejected a Democratic lawmaker's suggestion that he consider cutting interest rates to bolster the economy.

Bernanke, testifying for a second day on Capitol Hill, this time before the House Financial Services Committee, repeated that the Fed is likely to hold rates steady for a while if slower economic growth nudges inflation lower this year and next as expected.

But the Fed also thinks inflation is too high and might go higher, Bernanke said. If he and his colleagues adjust borrowing costs in coming months, they are more likely to raise rates than lower them.

"In order for this expansion to continue in a sustainable way, inflation needs to be well controlled," Bernanke said in response to remarks by committee Chairman Barney Frank (D-Mass.). "If inflation becomes higher for some reason, then the Federal Reserve would have to respond to that by raising interest rates."

Frank had told Bernanke the Fed's stance was "troubling" to him because the central bank also forecasts the economy will grow at a moderate rate this year, below its long-term average, and that inflation will drift lower over time.

"I don't see how we get a concern of inflation," Frank told Bernanke. "Why is there not at least an equal chance for there to be a reduction" in interest rates?

Bernanke responded that he and his Fed colleagues see several risks that the economy may not behave as forecast, and they would adjust interest rates as needed.

One possibility is that the economy weakens more than expected, perhaps if the housing slump deepens. Many private analysts have recently lowered their estimates of the economy's pace of growth because of a series of weak figures, including the Fed's report yesterday that U.S. industrial production fell in January.

But the Fed sees a greater risk of high inflation. Bernanke noted recent strong growth in consumer spending and incomes, "which suggests that the economy may be stronger than we think. It's possible."

If so, consumer demand might rise faster than the economy's ability to produce goods and services, he said. Already, the labor market is tight, with unemployment at a low 4.6 percent, and businesses' use of their production capacity is slightly above average, according to the Fed report.

The inflation risk lies in this danger of excessive demand, not in low unemployment alone, the Fed chairman said.

There is no specific level of unemployment that automatically triggers inflation, Bernanke, a former chairman of the Princeton University economics department, said in response to several lawmakers' questions.

That contrasts with the traditional view of many economists that unemployment below about 5 percent is inflationary. Bernanke's remarks partly reflect years of research that has debunked the idea of a long-term trade-off between unemployment and inflation. They also reflect the nation's experience in the late 1990s, when unemployment fell as low as 3.9 percent without causing much inflation.

The Fed's top policymakers forecast inflation to fall over the next 18 months while unemployment remains below 5 percent, indicating they are comfortable with joblessness so low.

Bernanke also said rising wages are not necessarily inflationary, as was widely believed in the 1970s when high inflation was blamed partly on unions' salary demands.

If businesses accept smaller profits -- they have been high lately -- companies can raise workers' wages without boosting prices, he said. Also, if labor productivity, or output per hour, rises quickly, businesses can produce more with the same labor force; again, workers' earnings can climb without pushing prices higher.

The low unemployment of the 1990s coincided with a takeoff in productivity growth. Bernanke's predecessor, Alan Greenspan, recognized this at the time and did not increase interest rates, despite the urgings of the Fed staff and some Fed Board members. The high inflation of the 1970s coincided with lousy productivity growth.

Productivity growth has slowed recently, but it remained solid at 2.1 percent last year. And Bernanke said "underlying productivity trends appear favorable."

Even so, he said, it is possible that strong economic growth "could allow firms to pass higher labor costs through to prices, adding to inflation," and that would erode the purchasing power of any wage gains.

© 2007 The Washington Post Company