US Economics: Upbeat Message Expected from Bernanke

Fed Chairman Bernanke is slated to deliver his semi-annual monetary policy report to Congress this week.
We expect a “steady as she goes” message, with the Fed chief citing an apparent pickup in the economy's growth pace following a very sluggish 1Q. At the same time, Bernanke is likely to note that while core inflation has drifted lower in recent months, there is some risk that this moderation may not be sustained.

There is considerable interest in what Bernanke will say about housing and the subprime mortgage market. We believe that he will continue to downplay the direct hit to the economy from the subprime debacle while also expressing some cautiousness that contagion remains a risk.

Why are Fed officials relatively sanguine about subprime? A little arithmetic will help to put things in context. Residential mortgage debt outstanding in the US currently totals about $10 trillion. Adjustable rate subprime represents roughly 8% of the market, or $800 billion. Many experts believe that about 20% of this debt will ultimately default. If we make a conservative assumption of a 50% loss on the underlying collateral, that means that the economic loss would total $80 billion (or 0.6% of GDP).

By comparison, the S&L crisis of the early 1990s triggered an economic loss of approximately $150 billion - or 2.5% of GDP (the US economy was a little less than half as large then as it is now). Moreover, the S&L-related losses were heavily concentrated in lending institutions located in certain regions of the US (e.g., California, Texas). In contrast, the losses associated with the current subprime problem appear to be dispersed throughout the global investor community. So, by itself, the scale of the subprime problem is relatively modest. It's the fear of contagion that represents the real threat to the economy.

What else will Bernanke say this week? We believe that the Fed's economic forecasts will need to be tweaked. In February, FOMC members were predicting 2 1/2-3% GDP growth this year. Because of the softness in 1Q, such a growth outcome now looks a tad aggressive. However, the unemployment rate is currently near the bottom end of the range of prior forecasts. Moreover, the core PCE is already a bit below the bottom end of the 2-2 1/4% range that had been projected for 2007.

Still, there is always a risk that high energy prices could spill over into core inflation, although it hasn't happened to this point. So the Fed Chairman will likely continue to talk tough on the inflation front. However, it's also becoming increasingly clear that the recent turmoil in the housing market is leading to a moderation in shelter costs. Indeed, the notorious owners' equivalent rent (OER) component of the CPI has slipped from a year-over-year pace of 4.2% back in February to +3.5% in May. A rising supply of rental units - in part reflecting the sizable inventory of unsold new homes and condominiums which are gradually transitioning to rental properties - means that the moderation in rents could continue. Indeed, we suspect that OER (a little more than 30% of the core CPI) could slip by as much as a full percentage point over the next year. This would definitely help contain core inflation.

Source: www.morganstanley.com