Economists were somewhat baffled by Wednesday’s congressional testimony from U.S. Federal Reserve Board chairman Ben Bernanke.

In a research note, BMO Capital Markets reports that it was rumoured that Bernanke would announce that the Fed was cutting the interest rate it paid on banks holdings of excess reserves in his congressional testimony. “Some have suggested that the rumor touched off yesterday’s rally in stocks,” it notes.

Instead, it says, his statement focused on ways the Fed “will drain reserves from the system and return its balance sheet to its pre-crisis size and average maturity when the economy approaches full employment — as though that is something the market is worrying about.”

“There is a real disconnect here, as he began his comments with the admission that the recovery has been weaker than expected,” BMO says, noting that the employment picture is a particular concern, credit remains constrained, business and consumer confidence are falling, and the housing market is still troubled, among other signs of weakness.

TD Economics notes that “near-term economic growth has disappointed and will more than likely come in below the FOMC’s projections for 2010”. And, for 2011, it says that most Fed officials expect growth to range from 3.5% to 4.2%. “While this is a modest downward revision from their earlier estimates, it is still substantially above our forecast of 2.9%. Thus, in our view, the balance of risks is to the downside of the Fed forecasts and augers for further downward revisions in the months ahead,” it says.

“The attention paid in both the speech and the addendum to impediments to credit growth, particularly to small business reveal a Fed that is concerned about the efficacy of monetary policy in stimulating demand,” TD says. “However, to this end, the Fed feels it still has some ammunition left in its arsenal should the economy take a turn for the worse.”

However, economists are somewhat skeptical of both the Fed’s approach, and its capabilities.

TD says that, “While monetary policy remains highly stimulative, the ability of the Fed to aggressively deal with further economic shocks is beginning to run thin.”

“It is difficult to understand why the Fed is taking this tact, especially as the fiscal stimulus is running out and some are calling for immediate fiscal restraint,” BMO says. “Why the Fed finds it prudent to emphasize its ability to re-normalize monetary policy when the output gap closes is beyond me. Deflation, not inflation, will be more troubling for the foreseeable future.”

IE