Federal Reserve

Chairman Ben Bernanke seemed to answer the question he's been asking since he took the helm of the Federal Reserve last February: Can the housing market recession pull the entire economy into contraction?

His answer seems to be finally that yes, it definitely could, though he refrained in his testimony to the Joint Economic Committee of Congress Thursday morning from explicitly discussing the prospects of a full-blown recession.

He says in his prepared testimony that delinquencies on mortgages "are likely to rise further in coming quarters as a sizable number of recent-vintage subprime loans experience their first interest rate resets."

"The contraction in housing-related activity seemed likely to intensify," he adds, and "house prices might weaken more than expected which could further reduce consumers' willingness to spend." That means the strong 3.9% GDP growth in the third quarter is "not likely to be sustained in the near term," due to tighter lending standards for all types of credit to both individuals and businesses.

The gist of Bernanke's testimony tilts toward the notion of stagflation, or the toxic combination of slow growth due to the housing market and credit market turmoil compounded by high raw materials prices, such as nearly $100 oil, and a weak U.S. dollar.

To summarize, the chairman said that the Fed sees growth as "remaining sluggish during the first part of next year, then strengthening as the effects of tighter credit and the housing correction began to wane."

The markets seemed at first to like what they heard, as his words support the chances of another federal funds interest rate cut when the Federal Open Market Committee meets again in December. Indeed, Bernanke's worry counters much of the more hawkish talk from Fed officials earlier this week that seemed designed to stem the markets' expectations for more monetary easing.

The fed funds futures market raised the odds of a December cut to 70% Thursday morning, after reaching just 50% earlier this week. The

Dow Jones Industrial Average

was briefly at the unchanged mark during his testimony, but it fell to a 70-point drop after the question-and-answer session.

Thursday's market action follows a dramatic 360-point decline in the Dow on Wednesday on expectations for more mortgage-related writedowns at banks and brokerage firms such as

Citigroup

(C) - Get Report

,

Morgan Stanley

(MS) - Get Report

,

Goldman Sachs

(GS) - Get Report

,

Merrill Lynch

(MER)

and others.

But it may be hard for some to trust the Fed's self-defined "hope" that the housing market will recover my mid-2008. Bernanke's comments Thursday are still a total about-face from his inflation focus through most of the year. And they are a far cry from the Fed's statement accompanying the Jan. 31 meeting of the Federal Open Market Committee, which stated that "some tentative signs of stabilization have appeared in the housing market."

When asked specifically about the chances of recession by Sen. Charles Schumer (D, N.Y.), Bernanke said that "economists are notoriously bad at turning points, and I wouldn't put the Fed in a different category."

He added that the Fed sees "moderate but positive growth in the next few quarters ... but by spring of next year, the housing problem, we hope, finds a bottom, that broader economy's reliance will take hold and help the economy recover to a more reasonable growth pace."

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click

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