Ben Bernanke on Tuesday fuelled market expectations of a vigorous bounce-back in US growth in the second quarter following very weak first-quarter growth.
The Federal Reserve chairman said first-quarter growth had been held down by factors such as an inventory adjustment, weak net exports and a slowdown in defence spending. These seemed likely to be at least partially reversed in the near term.
His analysis was reinforced by the latest Institute of Supply Management survey of activity in the service sector, which rose unexpectedly from 56.0 in April to 57.9 in May. The ISM’s May survey of manufacturing, published a few days ago, showed manufacturing activity up to 55.0, its highest level in 12 months.
US stocks fell and bond yields rose after Mr Bernanke’s speech and the ISM report as investors reacted to a lower likelihood of a rate cut later this year.
The yield on the policy sensitive two-year note rose above 5 per cent for the first time in nine months, while the yield on the 10-year bond reached a high of 4.99 per cent on Tuesday.
Weakness in stocks was broad based and the S&P 500 fell 0.7 per cent to 1,528.76, a day after setting a new record close.
The Bernanke remarks came at the annual International Monetary Conference, where Mr Bernanke, Jean-Claude Trichet, president of the European Central Bank, and Toshihiko Fukui, governor of the Bank of Japan, discussed global financial conditions.
Looking beyond the short term, Mr Bernanke said the Fed expected the economy to grow “at a moderate pace, close to or slightly below” its trend rate of growth over the coming quarters.
However, he said the housing correction was “still ongoing” and residential construction “now appears likely to remain a drag on economic growth for somewhat longer than previously expected”.
The Fed chief said there had been a gradual ebbing of core inflation but its current level was “somewhat ele- vated” – even though it was now just 2 per cent on the Fed’s preferred measure – and emphasised continued risks to price levels.
“The continuing high rate of resource utilisation suggests that the level of final demand may still be high relative to the underlying productive capacity of the economy,” he said.
In the discussion of world financial conditions, Mr Trichet reiterated his call for an industry-led code of conduct governing hedge funds, while Mr Bernanke said: “We look to them to develop a set of best practice principles, including such things as good risk management and good disclosure.”
The three central bankers agreed that the current level of global liquidity was exceptionally high, due in large part to the recycling of surplus savings in emerging markets and petrodollars from oil exporters.
Mr Bernanke said this kept global long term interest rates low, heightening the hunt for yield, which in turn prompted financial sector innovation that further narrowed the spread on risky assets.
Additional reporting: Michael MacKenzie in New York