Fed Chief Stays Cautious On Further Rate Cuts

Federal Reserve Chairman Ben Bernanke said the U.S. economy faces risks on both the growth and inflation fronts, suggesting the Fed will holding off deciding on further rate cuts.

Mary Altaffer / AP Federal Reserve Chairman Ben Bernanke.

"Financial market volatility and strains have persisted," Bernanke said in testimony prepared for delivery to the congressional Joint Economic Committee. "In addition, further sharp increases in crude oil prices have put renewed upward pressure on inflation and may impose further restraint on economic activity."

Policy-makers expect economic growth to slow "noticeably" in the fourth quarter of the year, the Fed chairman warned, saying a housing downturn was likely to intensify and that
consumer and business spending could slow.

However, he said the Fed expects growth to strengthen next year as the impact of tighter credit and the housing slump wane.

Bernanke's cautionary notes on growth weighed on stock prices and the dollar and gave a lift to prices for U.S. government debt, as investors saw it suggesting a somewhat greater likelihood of interest rate cuts ahead.

While some analysts agreed, others saw the Fed chief's testimony as finely balanced between concerns on growth and concerns over the potential inflation could quicken.

"They are pulled in two directions," said Christopher Low, chief economist for FTN Financial in New York. "They are worried about the economy. They are worried about inflation."

Bernanke In a Box

"Bernanke is in a box and it is getting smaller."
   
Bernanke told lawmakers that when Fed policy-makers met on Oct. 30-31, they saw both downside risks to economic growth and "important upside risks" to inflation, citing oil and other
commodity price increases and a drop in the dollar's value.

"These factors were likely to increase overall inflation in the short run and, should inflation expectations become unmoored, had the potential to boost inflation in the longer run as well," he said. Answering questions before the committee, he said it could be "very costly" if the Fed had to beat back a rise in inflation.

However, he also said delinquencies among holders of subprime mortgages were likely to rise. A sharp rise in home foreclosures could weaken the already struggling housing market and damage the broader economy, he warned.

The Fed has lowered benchmark interest rates by a cumulative three-quarters of a percentage point to 4.5 percent over the past two months to buffer the economy against the effects of financial market turmoil and the housing downturn.

Risks in Balance

At its most recent policy-setting meeting, the central bank said downside risks to growth were roughly in balance with upside risks for inflation, a statement that led many observers to believe the Fed would hold off lowering rates further.

Bernanke reiterated that view on Thursday.

Financial market instability has revived in recent weeks as major U.S. financial firms Citigroup and Merrill Lynch  have reported substantial write-downs due to investments linked to subprime markets.

Tighter credit following market turbulence is likely to restrain economic growth as borrowing costs rise, Bernanke said.

During the hearing, Bernanke also said:

• He is not concerned about changes in China's reserve holdings of U.S. assets.  "I'm not particularly concerned about the holdings of China or any other country," he said. "I don't see any significant change in the broad holdings of dollars around the world. Dollars remain the dominant reserve asset and I expect that to continue to be the case."

• The Fed does not take an "alarmist view" that a drop in U.S. home values will badly damage consumer spending. "We do not take the alarmist view on this," Bernanke said. "There are a number of factors at play right now including higher oil prices that would be a negative for consumer spending."

• The Fed can't protect investors from losses on mortgage securities. "In retrospect, it's surprising that sophisticated investors essentially looked at the credit ratings, and that's all they did, they didn't do due diligence and they didn't see what is in there,"

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