by Calculated Risk on 11/28/2006 05:23:00 PM

I watched Bernanke's speech, and my reaction was that he was very worried about future U.S. economic weakness. To my surprise, the always worth reading WSJ's Greg Ip wrote (see Economist's View for excerpts):

Mr. Bernanke's hawkish remarks on inflation and upbeat view of the economy contrast with the emerging view on Wall Street that the economy is weakening and inflation risks have faded.

Upbeat view? Sure, Bernanke was fairly positive looking forward, but reading between the lines, I believe Bernanke is very worried. Just last week, CEA Chairman Ed Lazear forecast Q4 GDP at 2.7%:

"We are projecting real GDP to grow at 3.1 percent in 2006, and that's on a Q4, quarter four to quarter four basis."

The annualized GDP for Q4 would have to be 2.7% to achieve 3.1% on a "quarter four to quarter four basis".

Today, Fed Chairman Bernanke projected Q4 GDP in the 1.6% to 2.6% range:

"... the indicators in hand suggest that real GDP growth this quarter is likely to be in the same general range that it was in the second and third quarters."

Although the Fed and the CEA are separate, Bernanke's forecast is clearly below Lazear's.

In additional to revising down Q4 GDP estimates, Bernanke made several comments that shows he is following housing very closely. Bernanke pointed out that housing prices have fallen more than reported due to incentives, noted that new home inventories are higher than reported - and by extension, new home sales are lower - due to significant cancellations. Contrast these comments with Fed Vice Chairman Kohn's recent comments from October 4th:

"... any overbuilding in 2004 and 2005 was small enough to be worked off over coming quarters at close to the current level of housing starts."

At that time housing starts were close to 1.7 million units (SAAR), and I suggested starts might have to fall to a rate of 1.1 million to work off the recent overbuilding. Since then, starts have already fallen to under 1.5 million (SAAR) and Bernanke is now suggesting there is more to come. Bernanke today:

"... we should keep in mind that even if demand stabilizes in its current range, reducing the inventory of unsold homes to more normal levels will likely involve further adjustments in production."

But one of the most telling comments from Bernanke was when he tried to offer some possibilities for an upside surprise in 2007:

"... economic growth could rebound more vigorously than now expected. The solid rate of job growth, the decline in the unemployment rate, and the healthy pace of capital investment could be signals that underlying economic fundamentals are stronger than generally recognized. Moreover, to date there is little evidence that the weakness in housing markets is spilling over more broadly to consumer spending or aggregate employment."

The rate of job growth and the unemployment rate are lagging indicators, and tell us nothing about future economic growth. Non-residential investment trails residential investment, so that is a weak argument too. Of course Bernanke's argument is that we are missing something and the strength in these areas is a reflection of that underlying strength. On the spillover from the housing bust into the general economy: any impact is ahead of us, not behind us.

Since Dr. Bernanke knows this, and chose to feature these indicators anyway, I'd guess that he thinks there is very little upside potential to his forecast. And plenty of downside risk.

Not to be outdone by Bernanke (just joking), Roubini lowered his Q4 estimate too:

"I have ... been arguing for months now that Q4 growth will be even lower than Q3 at between 0% and 1%. I am now comfortable to forecast that Q4 GDP growth will be closer to 0% than 1%."

And Roubini notes Deutsche Bank has also lowered their forecast:

In light of continued weakness in the economic data, we are cutting our fourth quarter real GDP growth forecast to zero from the +1.0% that we were originally predicting.

Bernanke looked like a deer in the headlights to me. Except this deer seems to have a good idea of what is coming.