Bernanke warns of weak economy

WASHINGTON -- Federal Reserve chairman Ben Bernanke painted a bleak picture of the economy Wednesday, suggesting tough times ahead for many Americans and all but guaranteeing further interest rate cuts as the central bank tries to avert the worst of the trouble.

Bernanke described a triple threat of little or no growth, more financial markets freeze-ups and rising inflation, an ugly combination that would raise unemployment and leave many would-be home buyers and business borrowers without funds. It would also be likely to erase the one silver lining of most downturns -- the lower prices that usually come when a recession reduces consumer spending.

This time, still-soaring oil and food prices suggest what may lie ahead is "stagflation."

"The economic situation has become distinctly less favorable," Bernanke told the House Financial Services Committee in his semi-annual assessment of the state of the economy.

The central bank, he said, "will be carefully evaluating incoming information bearing on the economic outlook and will act in a timely manner . . . to support growth and to provide adequate insurance against downside risks."

That is Fed-speak for reducing interest rates.

The fact that the Fed chairman was talking about more rate cuts in the face of elevated inflation is a measure of just how deep a quagmire the economy has landed in. Newly released figures show economic growth -- if it's still under way -- is increasingly endangered. Durable-goods orders fell 5.3 percent in January as companies cut spending.

At the same time, new home sales plunged to their lowest level since 1995 even as housing prices fell a record 15 percent from a year ago. And the dollar dropped to a record low against the euro, which can help boost exports but will raise the costs of imports and travel abroad.

Bernanke signaled that the Fed considers slow growth and financial market breakdowns so serious that it is likely to continue cutting interest rates, even if that means risking further fueling inflation.

Veteran Fed watchers said Bernanke's dark assessment was especially striking since his report to Congress in July was generally upbeat. He argued then that the subprime mortgage crisis and the housing slump largely were contained and would not spill over to the broader economy. Since then, both have done precisely that.

Some observers warned that the emphasis could change quickly. Once Fed policymakers believe that they have growth going again and financial markets back on track, they could make an abrupt about-face, and begin raising interest rates to try short-circuiting inflation and avoid fueling another bubble such as those in stocks during the late 1990s and in housing during the first half of the 2000s.

"You've got an inflation targeter (in Bernanke) who's ignoring inflation in favor of growth," said Diane Swonk, chief economist with Mesirow Financial in Chicago. "He's betting a slowing economy will moderate price increases" until the central bank can fix the growth and financial market problems, she said.

Bernanke has suggested in the past that the Fed set a target for inflation and raise or lower interest rates to meet the target.

The moment Fed policymakers are convinced they have licked the growth and financial markets problems, "you're going to feel the whipsaw," Swonk said, as the central bank pushes rates back up again.

She predicted a rate-raising campaign could begin by early 2009.

"It's not going to be a great time to come in as a new president," she said.

Since last fall, when the Fed became convinced that the economy was substantial trouble, it has sliced its key signal-sending interest rate 2 1/4 points to 3 percent in an effort to spur growth by pushing down the market set rates for such things as mortgages, cars, credit card debt and business loans. But its efforts have been largely stymied by increasingly nervous lenders demanding higher, not lower, rates. In many cases, they have refused altogether to provide would-be borrowers with funds.

Analysts predict that the central bank will slash another half point from the so-called federal funds rate -- the interest that banks charge each other for short-term loans -- when it meets next March 18, and could cut as much as another half point or more in the months to follow.

In part because of the rate cuts but in large measure because of surging food and fuel costs, consumer price climbed 4.1 percent last year, the most since the early 1990s. A government report Wednesday said that prices at the wholesale level climbed at a 7.4 percent rate in January, their fastest pace since the early 1980s.

Bernanke sought to portray the Fed as continuing to keep its eye on inflation. But he acknowledged that if inflation or people's expectations about inflation pick up, the results could be serious.

"Any tendency of inflation expectations to become unmoored or for the Federal Reserve's inflation-fighting credibility to be eroded would greatly complicate the task of sustaining price stability and could reduce the flexibility" of Fed policymakers to keep cutting rates in order to spur growth, he said.

In an economic forecast released last week, the Fed predicted that the economy will just dodge recession, growing at an anemic pace of less than 2 percent. Bernanke suggested Wednesday that even this slow-growth prediction may not pan out. During his testimony, he ticked through the various sectors of the economy and told lawmakers that conditions in almost all are worse now than when he last reported to Congress last summer.

He said the country faces a "continuing contraction" in the housing market despite the fact that new construction and sales have fallen to less than half their peak levels.

He said that consumer spending, which is at the heart of the economy and which held up for much of last year, has "slowed significantly" in recent months in large measure because of rising energy prices and dwindling house values.

He predicted that business sector investment in equipment and software "will be subdued" for at least the first half of the year, and that plant and office construction "is likely to decelerate sharply."

About the only bright spots that the Fed chairman could point to were that the manufacturers' inventory of unsold goods, which often rise in recessions, were still within bounds, and that most companies outside of banking and finance are in "good financial condition with strong profits, liquid balance sheets and corporate (borrowing) near historical lows."

AP-NY-02-27-08 2103EST