Fed Chairman Eases Jitters Over Inflation

Federal Reserve Chairman Ben Bernanke told bankers at the Kansas City Federal Reserve Bank’s economic symposium in Jackson Hole, Wyo. Friday that “the financial storm that reached gale force some weeks before [last year’s symposium] has not yet subsided, and its effects on the broader economy are becoming apparent in the form of softening economic activity and rising unemployment.”

Inflation has jumped as well, Bernanke said. The Fed has recognized this increase, but has kept rates low for Fed funds in an attempt to support the weakening economy. If the economy continues to soften and the dollar continues to gain strength, as it has recently, then inflation should moderate. Bernanke said that the moderation in inflation should take place “later this year and next year.”

However, Bernanke said, “the inflation outlook remains highly uncertain,” due in part to the difficulty in predicting prices for oil and other commodities. So the Fed will continue to watch inflation closely.

Financial markets responded positively to the speech, sending the Dow Jones Industrial Average up nearly 200 points at midday Friday. Generally, investors took the message to mean the Fed would not raise interest rates this year to combat inflation.

The Fed will also continue to offer additional liquidity to the market beyond the end of the year through specialized collateral lending programs, Bernanke added. “We will continue to review all of our liquidity facilities to determine if they are having their intended effects or require modification.”

Bernanke also said the Fed is looking at several different options to protect the country’s financial system from systematic risk, which was one of the elements that contributed to the Fed’s decision to step in during the collapse of Bear Stearns.

However, Bernanke stopped short of saying the Fed would step in if other financial services firms fail, as has been rumored with Fannie Mae and Freddie Mac.

“The collapse of Bear Stearns was triggered by a run of its creditors and customers, analogous to the run of depositors on a commercial bank. This run was surprising, however, in that Bear Stearns’s borrowings were largely secured,” Bernanke said. “However, the illiquidity of markets in mid-March was so severe that creditors lost confidence that they could recoup their loans by selling the collateral. Many short-term lenders declined to renew their loans, driving Bear to the brink of default.”

Improving clearing and settlements and migration of derivatives to more standardized financial instruments could help prevent another failure of a financial services firm, Bernanke said.