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Bernanke Signals More Rate Cuts

Nat Worden

Federal Reserve Chairman Ben Bernanke painted a gloomy picture of the U.S. economy in prepared Congressional testimony on Wednesday, signaling the central bank would continue to cut a key rate to boost the economy.

Bernanke reiterated the Fed's previous forecast for continued growth in 2008 and a downturn in inflation. The central bank's federal funds rate target has been lowered by 225 basis points since September with a stunning 125 basis points of that move coming in January alone.

"The [Federal Open Markets Committee] will be carefully evaluating incoming information bearing on the economic outlook and will act in a timely manner as needed to support growth and to provide adequate insurance against downside risks," Bernanke said.

At the end of January, the Fed lowered its forecast for U.S. economic growth in 2008 to a range from 1.3% to 2%, down from its previous forecast issued last summer for GDP growth of 2.5% to 2.75%. It also projected that the U.S. unemployment rate will rise to 5.2% or 5.3%.

"The risks to this outlook remain to the downside," said Bernanke. "The risks include the possibilities that the housing market or labor market may deteriorate more than is currently anticipated and that credit conditions may tighten substantially further."

Risks to the downside were highlighted in the market on Wednesday when Fannie Mae(FNM Quote - Cramer on FNM - Stock Picks), the government-sponsored mortgage giant, reported that it swung to a steep loss of $3.56 billion amid a rise in delinquency on mortgage payments from consumers.

The federal regulator of Fannie Mae and its counterpart, Freddie Mac (FRE Quote - Cramer on FRE - Stock Picks), announced shortly after the earnings release that it would lift its cap on their investment portfolios on March 1, in an effort to rejuvenate the secondary market for securitized mortgages. The cap was imposed on Fannie and Freddie after they had breakdowns in their financial reporting practices, but the Office of Federal Housing Enterprise Oversight said both companies have made "substantial progress" in fixing their internal controls and accounting systems.

Despite its lowered expectations, the Fed's forecast still stands in stark contrast to the widely-held belief among investors that the U.S. economy is either already in a recession or headed toward one. The government's early report for the fourth-quarter showed GDP growth of just 0.6%. That reading will be updated by the government on Thursday, and economists on Wall Street are expecting a small uptick to growth of 0.8%.

Meanwhile, the Labor Department reported a contraction in the U.S. job market in January -- the first on record since 2003. That signaled to investors that economic conditions are deteriorating in 2008, amid a dramatic slowdown in the U.S. housing market and relentless turmoil and uncertainty in the world's financial markets.

Bernanke's description of the economy in his testimony supported the notion that conditions are worsening.

"The economic situation has become distinctly less favorable since the time of our July report," said Bernanke. "Strains in financial markets, which first became evident late last summer, have persisted; and pressures on bank capital and the continued poor functioning of markets for securitized credit have led to tighter credit conditions for many households and businesses.

"The housing market is expected to continue to weigh on economic activity in coming quarters," he added.

Bernanke also noted that consumer spending appears to be slowing -- perhaps the most worrisome factor for investors -- and he said weak job growth is "yet another potential drag" on the economy.

Adding to the stress, Bernanke addressed recent data that shows rising inflationary pressures in the economy, but he reiterated the Fed's long-held belief that inflation will moderate as oil prices stop rising and the economy slows. That said, he also noted that upside risks to inflation have increased recently, with prices for crude oil, gold and other commodities soaring, while the value of the dollar has plunged.

"Should high rates of overall inflation persist, the possibility also exists that inflation expectations could become less well-anchored," said Bernanke. "Any tendency of inflation expectations to become unmoored or for the Fed's inflation-fighting credibility to be eroded could greatly complicate the task of sustaining price stability and could reduce the flexibility of the FOMC to counter shortfalls in growth in the future."

Having taken the reins from his predecessor, Alan Greenspan, at the end of a housing boom that was juiced by a long period of loose monetary policy, Bernanke faces a difficult task in guiding the Fed through the U.S. housing bust. On the one hand, financial markets could lose stability if the Fed stops providing cheaper credit. On the other, the continuation of low interest rates could unleash a dangerous spiral of inflation or give rise to more speculative bubbles in the markets.

"A critical task for the Federal Reserve over the course of this year will be to assess whether the stance of monetary policy is properly calibrated to foster our mandated objectives of maximum employment and price stability in an environment of downside risks to growth, stressed financial conditions, and inflation pressures," said Bernanke. "In particular, the FOMC will need to judge whether the policy actions taken thus far are having their intended effects."