Bernanke: Fed Ready to Cut Rates to Prevent Recession

Federal Reserve Chairman Ben Bernanke said the central bank was ready to cut interest rates again to prevent housing and credit problems from plunging the U.S. into a recession.

The Fed chief made clear the central bank was prepared to act aggressively to rescue a weakening economy. "We stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks," he said.

Federal Reserve Bank Chairman Ben Bernanke
Pablo Martinez Monsivais
Federal Reserve Bank Chairman Ben Bernanke

Some economists believe the Fed will slice its key interest rate by a bold half percentage point when the Fed meets next on Jan. 29 and 30. Others, however, think the Fed will go with a more modest one-quarter percentage point reduction, given concerns that high energy prices could spark inflation.

To bolster the economy, the Fed lowered its key rate three times last year. Its last cut on Dec. 11 left the rate at 4.25 percent, a two-year low. Still, Bernanke has come under criticism for not acting more aggressively to deal with the economy's problems.

Worries about America's economic health have gripped voters, galvanized presidential candidates and spurred the White House and Congress to explore ways to stimulate the economy to avoid a recession.

Hiring practically ground to a halt in December, pushing the unemployment rate up to 5 percent, a two-year high, the government said in a report last week that rattled Wall Street and Main Street.

Bernanke, in a speech to a housing and economic forum here, cautioned against reading too much into one report. However, he said that if employment conditions were to continue to deteriorate, that would raise risks to the economy. The big worry is that consumers might cut back on their spending, sending the economy into a tailspin.

Incoming information suggests that the outlook for economic activity for this year has worsened and that the "downside risks to growth have become more pronounced," Bernanke warned.

A housing slump, weaker home values, harder-to-get credit and high energy prices all "seem likely to weigh on consumer spending as we move into 2008," Bernanke said.

Many analysts predict upcoming reports will show the U.S. economy grew at a feeble pace of just 1.5 percent or less in the final three months of last year and will be weak in the first three months of this year as consumers _ major shapers of overall economic activity _ tighten their belts.

"Easing May Be Necessary"

In light of such risks to the economy's growth, "additional policy easing may well be necessary," Bernanke said.

Galloping energy prices _ oil recently surged past $100 a barrel before easing _ can put a damper on economic growth and can also spread inflation through the economy if they force companies to boost the prices of many goods and services.

Bernanke acknowledged the situation could complicate the Fed's job of trying to keep the economy growing, while making sure that inflation is under control.

So far, he said, people and companies have "reasonably well-anchored" expectations about where they think inflation will head in the months ahead, Bernanke said. "However, any tendency of inflation expectations to become unmoored or for the Fed's inflation-fighting credibility to be eroded could greatly complicate" the Fed's task of maintaining stable prices, he said.

U.S. stock markets surged after Bernanke's comments, while the dollar remained weaker against a basket of currencies as investors concluded that the Fed would aggressively lower
interest rates at its end-of-month policy-setting meeting.

Bernanke, known for a higher degree of transparency than his predecessors, has shown a recent tendency to let Wall Street know when the Fed sees significant changes in economic conditions, which may warrant Fed policy moves.

Revising Estimates Upward

Though high-profile Wall Street firms such as Merrill Lynch and Goldman Sachs recently joined the doom-and-gloom chorus of recession predictors, there's hardly a consensus that the economic slowdown will yield outright contraction. In fact, economists are now revising their estimates of fourth-quarter growth upward, not downward, thanks to surprisingly strong consumer spending.

On the labor front, the government Thursday said weekly jobless claims fell 15,000 in the most recent week to 322,000. That's significantly below the more telling four-week average of 341,000 and follows a worrisome jump in the unemployment rate in December. That report last Friday -- showing the jobless rate up three-tenths of one percent to 5.0 percent -- ringing recession alarms on Wall Street.

Given those shifting sands, some Fed watchers say Bernanke has no choice but to be cautious, especially since the Fed has already lowered rates one full percentage point.

"I think many in the markets would like Bernanke to make some clear statement about where interest rates are going, but I don't think he can do that," says Kristin Forbes of the MIT's Sloan School of Management.

Forbes says it is simply too soon before the Fed's Jan. 30-31 policy meeting for Bernanke to do that without boxing the Fed in.

Inflation Still a Threat

Other economists warn that the Fed still has a fight with inflation on its hands, particularly because of high energy prices, which could percolate through the broader economy.

"I do think the Fed should be cutting rates, but the Fed needs to be wary about how it is cutting rates because of inflation risk," says Robert Brusca, chief economist at FAO Economics.

Brusca notes that CPI has frequently registered 0.2 percent monthly increases, more than the Fed would like.

There's also enormous uncertainty about how much of a drag the housing recession will continue to exert on the economy. Though many expect housing to continue to decline in 2008, the pace is likely to slow. The same goes for the so-called credit crunch, which flared again recently with rumors of a possible bankruptcy at Countrywide Financial, a scenario the company flatly denied.

David Resler, chief economist at Nomura International, says housing took one percent off GDP growth in 2007. He's in the midst of revising his economic outlook, which at this point, and says, nothing about his forecast could characterize a recession."

Too Early to Tell

St. Louis Federal Reserve Bank President William Poole recently offered the same conclusion, saying it it too early to tell if recession is in the cards.

Going forward, Resler and other economists are looking at the release of industrial production data on Jan. 16 and durable goods report two weeks later. That will be particularly telling given that the ISM's manufacturing index registered below 50 in December, which indicates that part of the economy is contracting. What's more, both December's payroll and unemployment data pointed to weakness in the manufacturing sector. The Fed will no doubt be looking closely at that data.

Though Bernanke has earned somewhat reluctant praise from Wall Street for his handling of the credit crunch, there are still lingering doubts in some corners.

“This is a market that I don’t think has a lot of confidence in him," says Scott Martin
Astor Asset Management. "I’m worried that if comes out and is a little bit unclear as to how he feels about the economy and whether there is a Fed rate-cut emergency style, It think the market probably sells off initially on his testimony.”