Fed Chief Endorses Stimulus

Updated from 11:07 a.m. EST

Federal Reserve Chairman Ben Bernanke supported the case for both easy monetary policy and fiscal stimulus in his comments on Capitol Hill Thursday morning.

After outlining the string of events that led the Fed to forecast a weak growth environment for the U.S. economy in 2008 and perhaps into 2009, Bernanke, in a question-and-answer session after his speech, said a stimulus package "would be significant, not just window dressing." As he did in another speech a week ago, Bernanke also promised the central bank will ease interest rates if and when needed.

"The baseline outlook for real activity in 2008 has worsened and the downside risks to growth have become more pronounced," said Bernanke in his testimony. The chairman noted the continuing recession in the residential real estate market and made mention of "disappointing" labor market conditions that threaten consumer spending trends, which have helped support growth through the third quarter of 2007.

Bernanke also highlighted "sluggish" corporate spending at the end of the year. Stronger export activity was really the one strong point the chairman could identify as a possible offset to the weak growth forecast.

Bernanke's testimony capped an already tumultuous morning for the markets. The S&P 500 Index was down 23 points, or 1.7% by midday, and the Dow Jones Industrial Average was down over 150 points, or 1.2%. Merrill Lynch(MER) began the day by reporting a nearly $10 billion loss, and a $14.6 billion writedown tied to bad loans, sending its stock down over 8% by midday. Topping off that news, the Philadelphia Fed survey of manufacturing activity in the region plummeted to a -20.9 reading in January, its lowest level since October 2001.

The chairman's gloomy outlook aside, he offered up a soothing tone by noting that the U.S. economy is "resilient," and said he is willing to use the Fed's tools to offset weakness as quickly and effectively as the central bank can. Bernanke's comments support the chances of a 50 basis point rate cut come Jan. 29, the next meeting of the Federal Open Market Committee.

"In light of recent changes in the outlook for and risks to growth, additional policy easing may well be necessary," he said. "We stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks."

The fed funds futures market is currently pricing in certainty of at least 50 basis points of fed funds rate reductions by the end of the month, according to Miller Tabak. That market is starting to price in an intermeeting cut as well, and 40% odds of a 75 basis points of fed funds rate cuts by the end of the month. Currently the fed funds rate stands at 4.25% after one 50 basis point rate cut last September, and two 25-basis point cuts at following meetings. The Fed has also been actively injecting liquidity in the global financial marketplace via its Term Auction Facility, an attempt to bring down market-based interest rates like Libor and ease short-term money markets.

Bernanke didn't stop there. He also opened the door to possible emergency or intermeeting cuts, as needed.

"Financial and economic conditions can change quickly," said Bernanke, adding that "the FOMC must remain exceptionally alert and flexible, prepared to act in a decisive and timely manner, and in particular, to counter any adverse dynamics that might threaten economic or financial stability."

Fiscal stimulus, he says could augment monetary policy solutions to stem economic weakness. Answering questions following his testimony, Bernanke said a quick, temporary, and effectively targeted stimulus to U.S. citizens could "provide a broader base of support than just monetary policy can achieve."