Bernanke says U.S. economy faces big threat

Source Reuters

NEW YORK (Reuters) - Federal Reserve Chairman Ben Bernanke said on Wednesday that turmoil in credit markets poses a "significant threat" to the U.S. economy, suggesting more interest-rate cuts could be coming to help stave off a deep downturn.

Bernanke said it will take some time to restore normal credit flows and pledged the U.S. central bank would continue to act aggressively to fight the crisis. Importantly, he said inflation risks were ebbing, which suggests Fed officials see latitude to lower borrowing costs further.

"By restricting flows of credit to households, businesses, and state and local governments, the turmoil in financial markets and the funding pressures on financial firms pose a significant threat to economic growth," Bernanke told the Economic Club of New York.

"We will continue to use all the tools at our disposal to improve market functioning and liquidity," he said, adding that policy-makers' aggressive and quick response crucially distinguished this episode from the crisis of the 1930s.

U.S. stocks, already down sharply on Wednesday on news of an unexpectedly big drop in September retail sales and weak factory data, sold off even more after the Fed chairman's dour assessment and finished the day with their largest percentage losses since the 1987 crash.

St. Louis Federal Reserve Bank President James Bullard said the sharp 1.2 percent drop in retail sales increased the risk of recession. "The third quarter, I think, will be flat to slightly negative," he told reporters in Little Rock, Arkansas. "That is going to push up the probability that it will later be named a recession.

RATE CUT SEEN

The data contributed to expectations that Fed officials will follow up an emergency interest rate cut made last week with another reduction at their next meeting on October 28-29.

Last week, in concert with central banks around the globe, the Fed cut benchmark rates by a half point to 1.5 percent. It said an intensification of the financial crisis had raised risks to growth, while curbing the risk of inflation.

In the latest bid to restore financial market stability, the U.S. government on Tuesday announced a dramatic plan to recapitalize banks, beginning with a $125 billion equity investment in nine major financial institutions.

But even with the government scrambling to restore credit, Bernanke cautioned it will take time for the economy to heal.

"Stabilization of the financial markets is a critical first step, but even if they stabilize as we hope they will, broader economic recovery will not happen right away," he said.

Analysts said Bernanke's words suggested the Fed chief saw the deteriorating outlook as calling for another rate cut.

"Bernanke's comments ... reinforce the sense that the Fed will lower interest rates when it meets again," said Tony Crescenzi, chief bond market strategist at Miller, Tabak & Co in New York.

FEW BRIGHT SPOTS

A Fed report prepared for the central bank's next meeting added to the gloomy news about the economy.

The Beige Book said economic activity had weakened across the country in recent weeks as businesses revisited capital investment plans, consumers curtailed spending and labor markets softened. The Fed described business contacts as "pessimistic."

In his speech, Bernanke said the housing sector remained the economy's weakest spot, but he also cited "marked slowdowns" in consumer spending, business investment and the labor market.

He added that credit markets would take time to unfreeze and said export sales, until recently a bright spot, were likely to slow as well.

While inflation had been high recently, Bernanke said expectations of future inflation had held steady or eased, import prices were moderating and commodity prices had fallen.

Those factors, along with the softness in the economy, "should lead to rates of inflation more consistent with price stability," he said. "I think the evidence is now in that the inflation problems are moderating and look to be returning to price stability at a reasonable pace."

Boston Fed President Eric Rosengren was more direct.

"One of the characteristics of a recession is in each of these recessions the inflation rate has come down quite dramatically," he told a real estate group in Boston.

"We're in a period when the economy is likely to grow quite slowly. The events of the last couple of weeks certainly aren't going to help.