Bernanke gloomier about near-term prospects

U.S. economy could even contract in the first half, Fed chief says

By Greg Robb, MarketWatch

Last update: 2:24 p.m. EDT April 2, 2008

WASHINGTON (MarketWatch) -- The outlook for U.S. economic growth has worsened since January and the possibility of a recession can't be ruled out, Federal Reserve Chairman Ben Bernanke said Wednesday.

"It now appears likely that real gross domestic product will not grow much, if at all, over the first half of 2008 and could even contract slightly," Bernanke said in testimony prepared for the Joint Economic Committee of Congress.

"Clearly, the U.S. economy is going through a very difficult period," he said. Real GDP measures the value of all final goods and services produced by a country, adjusted for the rate of inflation.

Bernanke clung to the distinction that the "contraction" may not turn into a "recession." But economists said this was exceedingly rare.

The rule of thumb is that a recession is two quarters of negative real GDP growth. But the National Bureau of Economic Research has the formal role of naming a recession and their deliberations are more technical, elaborate, and, consequently, slow.

The financial markets' turmoil is already dampening growth, Bernanke said, leading the central bank to cut its near-term forecast once again. The Fed has been steadily reducing its outlook for growth this year. The current forecast is growth in a range of 1.3% to 2.0% over the four quarters of the year.

In light of the markets' recent turbulence," the uncertainty of this new gloomier forecast is quite high and risks remain to the downside," Bernanke said.

'Clearly, the U.S. economy is going through a very difficult period.' — Ben Bernanke, Federal Reserve

In spite of the Fed's string of interest-rate cuts and extraordinary efforts to push cash out to commercial and investment banks, "financial markets remain under considerable stress," he said.

His statement supports the view that the Fed is not done cutting interest rates. The central bank has lowered its target overnight lending rate to 2.25% from 5.25% last fall, the largest percentage decline on record.

Despite the new forecast, Bernanke's language suggested the U.S. central bank wants to slow down the pace of its rate cuts.

"Much necessary economic and financial adjustment has already taken place, and monetary and fiscal policies are in train that should support a return to growth in the second half of this year and next year," he said.

Bernanke did not back away from the view that the economy would pick up in the second half of this year. Growth could even expand at a faster pace than trend growth in 2009, he said. Trend growth is the rate the economy can grow without fueling inflation pressures. Economists generally put this rate around a 2.75% growth rate.

It is also important what Bernanke did not say.

He failed to repeat the key dovish statement that the FOMC would "act in a timely manner" to support growth.

Another factor arguing for a slower pace of rate cuts is inflation: Bernanke said that rising prices remain a concern.

More importantly, the public seems to be expecting prices to continue to rise in coming months. This has been a key focus of monetary policy. They have said that once consumers expect rising prices to continue, these higher prices tend to stick.

Defense of Bear Stearns bailout

On another important subject, Bernanke defended the Fed and Treasury Department's bailout of Bear Stearns Cos. before the lawmakers.

Bernanke disclosed publicly for the first time that Bear Stearns advised the Fed and Treasury on March 13 that its liquidity position had so deteriorated that it would have to file for Chapter 11 bankruptcy the next day unless alternative sources of funds become available.

On March 14, the Fed stepped in and effectively put a force field around Bear Stearns' assets, preventing a fire sale. The following weekend, the Treasury and Fed engineered the sale of Bear Stearns to J.P. Morgan Chase & Co. , one of the nation's largest institutions.

Bernanke said the prospect of Bear Stearns having to declare bankruptcy was untenable.

"With financial conditions fragile, the sudden failure of Bear Stearns likely would have led to a chaotic unwinding of positions in those markets and could have severely shaken confidence. The company's failure could also have cast doubt on the financial positions of some of Bear Stearns' thousands of counterparties and perhaps of companies with similar businesses," he said.

The Fed didn't receive any early-warning notice that Bear Stearns was teetering on the brink of collapse until the company disclosed to the government that it would be forced to file for bankruptcy in 24 hours, Bernanke said.

The Fed had relied on the Securities and Exchange Commission's finding that Bear Stearns had adequate capital, he said.

Bernanke said the short notice of possible bankruptcy was not normal.

"Normally, we would have more warning and we would have more time to develop a more effective response," Bernanke said.

The collateral that the Fed accepted from Bear Stearns in return for a $29 billion loan could be sold to recover the full amount of the loan, according to Blackrock Inc. , the asset manager hired by the Fed to control those assets, Bernanke said.

Members of the committee were generally supportive of the Fed and Treasury decision to save Bear Stearns from bankruptcy. But they called for similar help for "Main Street" as opposed to "Wall Street."

Bernanke said the Fed's decision to open its key lending window to investment banks and other steps have helped address some of the strains in financial markets.

Downturn's attendant woes

In his discussion of the economy, Bernanke said the U.S. unemployment rate is likely to rise in coming months as companies cut back their hiring plans.

At the same time, he said, there's been no sign of a bottom in the housing market's downturn, with construction expected to fall further.

Hopes that major trading partners will be able to keep the U.S. economy afloat have faded a bit, as Bernanke said the outlook for foreign economic growth has diminished somewhat in recent months.

Congress could help rescue the housing sector by repairing the mortgage market and not just focusing on keeping existing home loans from going bad, Bernanke said.

"Going forward, for the housing market to recover, it would be helpful for the mortgage markets to be working more effectively and more efficiently," Bernanke said.

The depressed housing market remains at the center of the U.S. economy's current difficulties and some of the "worst problems" are in the mortgage area, Bernanke said.

In particular, the nonconforming segment of the mortgage market "continues to function poorly," he said.

Bernanke also said that reform of Fannie Mae ) and Freddie Mac would be a good step and that these two firms should raise additional capital.