Jul 24 2006 11:46AM | Permalink | Email this | Comments (1) |
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Chairman Bernanke gave the fed’s periodic report to Congress on the state of the economy in the fed’s usual “oracle” style. This style requires that every forward looking statement be modified by an accompanying “on the other hand” caution. It also requires that any forecast be described by a number or a date but never both. Investors interpreted his comments as positive for stock prices but marginally negative for the value of the dollar and acted on these interpretations instantly.

Fortunately, contractors and their suppliers do not have to react instantly. But those who wait too long will be at a disadvantage. Here is how to interpret the fed report for the construction outlook. Basically, Bernanke said stick to your business. The Federal Reserve Board has the risks to the economy under control.

Bernanke said that the slowing of economic growth from above average to average is not unexpected, is typical at this late stage of a business cycle and is very unlikely to deepen into a prolonged period of below average growth through 2007. Also inflation and wages typically rise at this point in the business cycle so the recent sharp rises are not necessarily a reason for countervailing action by the central bank. While shortages of oil and other commodities have pushed inflation slightly above the fed’s upper comfort limit, the causes are largely political and meteorological and thus are not likely to be sustained so inflation is set to subside slightly through next year.

The fed has made its policy management model very clear. Interest rates will be raised to trim demand and thus inflation in proportion to the perceived risk both of inflation getting into wages and inflation boosting inflation expectations. Bernanke was very clear that the impact on wages has been very modest because productivity remains high. He also noted that the standard measure shows inflation expectations to be just over the comfort limit, generally stable and actually declining recently when inflation reports have been disturbingly high.

Investors correctly interpreted the fed report to mean that there is little risk of further interest rate increases although another 0.25% rise in August has not been ruled out. Translated to construction, this means that housing will remain sluggish, probably averaging near the 1.850 million starts reported for June but that the balance of the construction market will continue to expand rapidly along with other business investments.

Don’t overlook Bernanke’s cautions. Either a pick-up in the growth of wages or a change of attitudes that results in much higher inflation expectations will quickly bring a strong response by the Federal Reserve Board. Another period in which consumers and business buy now to beat future inflation and in which wages become automatically linked to inflation changes is the fed’s worst nightmare. It took nearly a decade of sluggish economic growth and double-digit credit rates to break the last wage-price cycle. The fed response would not be one or two more 0.25% rate hikes if a new wage-price spiral is looming. It could be several hundred basis points, enough to crash the housing market and bring an end to expanding business investment.