Federal Reserve Chairman Ben Bernanke’s semiannual testimony on monetary policy to the Senate revealed increasingly bearish views on the US economy, and mounting concerns about rising inflation pressures. Indeed, Mr. Bernanke noted the “considerable stress” that financial markets and institutions remain under and the concerns surrounding the health of Fannie Mae and Freddie Mac. Nevertheless, the Federal Reserve appears ready to do whatever it needs to do, as Mr. Bernanke said that "healthy economic growth depends on well-functioning financial markets and “helping the financial markets to return to more normal functioning will continue to be a top priority of the Federal Reserve.”
Focusing on the economy specifically, Mr. Bernanke mentioned the weakness in the labor markets, housing sector, stagnation in real earnings, tightening of credit conditions, and sharp drop in consumer sentiment, all of which is likely to restrain consumer spending “over coming quarters.” Meanwhile, inflation remains of great concern, and according to Mr. Bernanke, “FOMC participants viewed the inflation outlook as unusually uncertain and cited the possibility that commodity prices will continue to rise as an important risk to the inflation forecast.” The greatest concern, however, is that increasing prices “might lead the public to revise up its expectations for longer-term inflation.”
Overall, instability in the financial sector and looming downside risks to the economy create perilous conditions for the US, and despite the threat of rising inflation, the Federal Reserve has little room to fight that threat with increases to the fed funds rate. Furthermore, with the economic slowdown likely to quell domestic demand, inflation pressures are likely to ease on their own over time. – Terri Belkas, Currency Analyst for DailyFX.com