Bernanke Foiled as Fannie-Freddie Rescue Thwarts Forecasts

By Craig Torres and Steve Matthews

July 15 (Bloomberg) -- For Federal Reserve Chairman Ben S. Bernanke, events keep getting in the way.

The chairman is seeing his efforts at using forecasts to map an anti-inflation strategy shoved aside by the need to contain immediate damage to the economy, Fed watchers say. Bernanke today delivers his semiannual testimony on the economy to Congress, where he will release the projections officials discussed at their June 24-25 meeting.

``Things are out of his control,'' said John Silvia, chief economist at Wachovia Corp. in Charlotte, North Carolina.

Silvia, who used to work as chief economist of the Senate Banking Committee, where Bernanke testifies today, predicted that lawmakers' questions will mostly focus on how the financial crisis that has now engulfed Fannie Mae and Freddie Mac will ``affect the downside for the economy.''

Traders, who last month foresaw an interest-rate increase as soon as August, now anticipate the Fed will hold off until October, with the chance of a move by year-end dropping to 67 percent from 100 percent, futures contracts show.

The hearing is scheduled for 10 a.m. in Washington.

Bernanke last month said that the risks of a ``substantial downturn'' had diminished, and committed to ``strongly resist'' any jump in inflation expectations. The remarks spurred traders to bet the Federal Open Market Committee would raise its benchmark rate by year-end.

Stocks Slide

Risks to that outlook have risen after the Standard and Poor's Financials Index dropped 17 percent and Fannie Mae and Freddie Mac, the largest sources of U.S. home financing, lost more than half their value since the June FOMC meeting.

The U.S. Treasury and Fed were forced to assemble a rescue plan for Fannie and Freddie July 13 in an effort to stem a collapse of confidence in the firms. Two days earlier, the Federal Deposit Insurance Corp. took over IndyMac Bancorp Inc. as the California lender collapsed under soaring losses.

``The Fed's messages, complicated by the interaction between the real economy and financial system, have been confusing,'' said Mark Spindel, who runs the Washington-based hedge fund Potomac River Capital LLC and used to manage a $15 billion portfolio at the World Bank's International Finance Corp. ``They were hoping financial turbulence would have subsided. It hasn't at all.''

Paulson, Cox

Bernanke's economic outlook may also be overshadowed by the crisis today because Senator Christopher Dodd, who chairs the banking committee, said it will be ``brief.'' That's to accommodate a separate hearing with Bernanke, Treasury Secretary Henry Paulson, and Securities and Exchange Commission Chairman Christopher Cox on financial markets.

Bernanke has pushed the FOMC to tie policy to an intermediate forecast. Under his guidance, Fed governors and district-bank presidents since October have published their projections four times a year, up from twice previously. The estimates are now for the coming three years, instead of two.

The strategy has been tested over the past year as bouts of financial turbulence clouded the economic outlook, forcing officials to alter their messages.

Policy makers on Aug. 7 kept their benchmark lending rate unchanged at 5.25 percent, and cited inflation as the ``predominant policy concern.'' Ten days later, a surge in funding costs prompted them to reverse course and lower the charge for direct loans to banks.

Changing Tack

Two months later, the FOMC said that growth and inflation risks ``roughly balance'' each other, before abandoning that assessment to lower rates again in December and execute an emergency reduction in January.

In June, Bernanke began highlighting a rising risk of inflation, presaging the June 24-25 FOMC meeting, where officials halted their series of seven rate cuts since September.

Consumer prices probably climbed 4.5 percent in June from a year earlier, close to the fastest pace since 1991, economists project a Labor Department report will show on July 16. Inflation has been stoked by soaring costs of fuel and food, with crude oil prices reaching a record $147.27 a barrel on July 11.

The Fed chairman's challenge today is to explain how the Fed will manage inflation risks without signaling that policy makers are preparing to raise rates, economists said.

``Financial developments have planted a few extra land mines'' for Bernanke, said Tom Gallagher, managing director in Washington for ISI Group, a money management and research firm. ``He will not want to unsettle markets, but he can't appear'' soft on inflation, Gallagher said.

Stock Slump

Fannie Mae has fallen 61 percent in the past month, and Freddie Mac has lost 69 percent. The declines in the companies that own or guarantee about half of the $12 trillion in U.S. home loans outstanding threaten to increase mortgage rates, deepening the worst housing recession in 25 years.

Paulson proposed two days ago legislation giving the Treasury the power to make unlimited purchases of equity in the firms, and to increase their credit lines. In the interim, the Fed agreed to let Fannie Mae and Freddie Mac borrow directly from the central bank.

``The Fed's message that substantial downside risks have diminished now just seems completely ill-timed,'' said Brian Sack, senior economist at Macroeconomic Advisers LLC. ``It is hard to see them tightening anytime this year.''

To contact the reporters on this story: Craig Torres in Washington at ctorres3@bloomberg.net; Steve Matthews in Atlanta at smatthews@bloomberg.net.