Bernanke Spooks Investors With Market Outlook

Federal Reserve Chairman Ben Bernanke spooked investors by saying a full recovery in financial markets may not happen right away.

"Conditions in financial markets have shown improvement since the worst of the storm in mid-August," Bernanke told the New York Economic Club Monday night. "But a full recovery of market functioning is likely to take time, and we may well see some setbacks."

The Fed chairman also said the central bank will act as needed to support market stability as well as sustainable growth and stable prices, signaling that more rate cuts will be needed.

J. Scott Applewhite / AP

"For now, the Federal Reserve will continue to watch the situation closely and will act as needed to support efficient market functioning and to foster sustainable economic growth and price stability."

Bernanke's remarks prompted a market selloff  Tuesday as investors worried that housing and the economy will continue to drag on stocks.

"We had a straight up run in the markets from the time the Fed starts easing which was really August," said Benjamin Pace, equity strategist at Lehman Brothers Private Investment Management. "We're being reminded of why the Fed had to ease."

The U.S. central bank lowered benchmark overnight interest rates by a surprisingly large half-percentage point to 4.75 percent on Sept. 18. Bernanke said that "by doing more sooner" the Fed hoped it could forestall any damage to the economy from financial disruptions triggered by mortgage delinquencies.

At the same time, policy-makers were prepared to reverse course and raise borrowing costs if inflation pressures -- which seemed to have moderated -- rekindled, he said.

Asked by a member of the audience about the impact of a weaker dollar, Bernanke said: "One cannot deny that when the dollar depreciates there is some inflationary impact," but added that the impact had been smaller in recent decades.

The Fed chief also said that expectations for slower growth would underpin hopes that price gains would moderate and that the central bank remained focused on keeping inflation low.

Bernanke said policy-makers considered the possibility that the Fed's move to cut rates to restore stability to financial markets might promote "excessive" risk-taking.

But the Fed reasoned that improved market functioning would increase chances of putting the economy on track for noninflationary growth during a period of strain.

"Developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy," he said.

The Fed meets again Oct. 30-31 and markets see a 32 percent chance that policy-makers will cut benchmark overnight borrowing costs by a quarter-percentage point then, as implied by short-term federal funds futures.

Economic information published since the September Fed meeting points to the housing slump exerting a "significant" drag through early 2008, Bernanke said. The Fed is closely monitoring whether tighter credit has affected business or household spending, he added.

Bernanke further said the Fed would keep close watch on employment and labor income, since any income gains would support consumer spending even if home values stagnate or fall. "The labor market has shown some signs of cooling, but these are quite tentative so far, and real income is still growing at a solid pace," he said.

From a regulatory standpoint on the credit crisis, Bernanke said that investment vehicles needed to be as transparent as possible.

He also said that it was difficult for the central bank to identify asset bubbles early enough to deal with them with "blunt" policy tools. Product and technological innovations can sometimes lead to excesses, he said.

"One of the downsides of innovation is that you make mistakes. If you want progress, you have to let the system work. If you want to be tougher and try to restrain excesses, you may sacrifice something in exchange."