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Eyes on the Fed Full coverage

Bernanke warns on economic growth

Fed chairman says he remains concerned about credit crunch and oil prices - and traders now think another rate cut is near certain.

By Paul R. La Monica, CNNMoney.com editor at large

NEW YORK (CNNMoney.com) -- Federal Reserve Chairman Ben Bernanke, warning that higher inflation and weaker economic growth could be in store, told Congress Thursday that the central bank is keeping a close eye on the subprime mortgage crisis and recent spike in oil prices.

Bernanke, testifying before Congress' Joint Economic Committee, said the Fed expected growth to slow "noticeably" in the fourth quarter. But he also downplayed fears of a recession, saying the central bank expects the economy to grow next year, albeit at a more moderate pace than in recent quarters.

ECONOMY FED FOCUS

Since the Fed cut interest rates on Oct. 31, "financial market volatility and strains have persisted," Bernanke said.

"Incoming information on the performance of mortgage-related assets has intensified investors' concerns about credit market developments and the implications of the downturn in the housing market for economic growth," Bernanke said in his prepared remarks.

He also expressed concern that the rise in energy prices - oil is now trading at about $96 a barrel - could lead to both higher inflation and weaker levels of economic growth.

"In addition, further sharp increases in crude oil prices have put renewed upward pressure on inflation, and may impose further restraint on economic activity."

Wall Street interpreted Bernanke's comments as a sign that the Fed may now be more likely to cut a key short-term interest rate at its next meeting on Dec. 11.

The Fed lowered the federal funds rate, an overnight bank lending rate that impacts how much consumers pay for credit card debt, home equity lines of credit and auto loans, by a quarter of a percentage point on Oct. 31. That move followed a half-point rate cut on Sept. 18.

According to futures listed on the Chicago Board of Trade, investors as of late Thursday were pricing in an 88 percent chance that the Fed will lower the federal funds rate by a quarter of a point to 4.25 percent in December. Earlier this morning, traders were pricing in a 70 percent chance of a rate cut.

"The Fed may be forced into further easing," said Ashraf Laidi, chief currency analyst with CMC Markets U.S, a currency brokerage firm. "The Fed may cut rates even it doesn't want to."

Nonetheless, stocks fell Thursday and one market expert said investors might now be worrying about the possibility of stagflation: sluggish economic growth combined with inflation.

"The Fed is in a tight spot. It's hard to combat deflation in housing and inflation in commodities spurred by a falling dollar at the same time," said Mike Larson, an analyst with Weiss Research, an investment research firm based in Jupiter, Fla.

However, Bernanke also said that recent economic data releases "suggest the overall economy remained resilient in recent months."

But in opening remarks before Bernanke's testimony, Sen. Charles Schumer (D-N.Y.), the chairman of the joint economic committee, said that he has begun to worry about the threat of a recession.

"I think we are at a moment of economic crisis stemming from four key areas: falling housing prices, lack of confidence in creditworthiness, the weak dollar and high oil prices," Schumer said. "Each of these problems alone would be enough of a threat to our economic well-being. But taken together, they are essentially the four horsemen of economic crisis."

For his part, Bernanke said during a question-and-answer portion of the hearing that "the spillover to the economy from housing still appears to be limited" and that it was the Fed's hope that the housing market would "find a bottom" by next spring.

Bernanke declined to specifically answer a question from Schumer about what, on a scale of 1 to 10, he thought the chances of a recession were.

A recession has historically been defined as two consecutive quarters of declines in gross domestic product. But the National Bureau of Economic Research now officially defines a recession as "a significant decline in economic activity spread across the economy, lasting more than a few months."

On Thursday, Bernanke warned that delinquencies for subprime mortgage borrowers are likely to rise further but that the Fed will continue to work with community groups to help borrowers avoid foreclosure.

What's more, he said that the Fed is on track to "propose rules by the end of this year to address unfair or deceptive mortgage lending practices" that would "apply to subprime loans offered by any mortgage lender."

When the Fed cut rates on Oct. 31, it cited an "intensification" in the housing market's weakness.

But the central bank also hinted in its statement that it may not cut rates again at its next meeting since it felt that "strains in financial markets have eased somewhat."

That was before a slew of negative developments from financial institutions that have caused investors to worry about problems stemming from the subprime mortgage meltdown.

Since the Fed cut rates, Citigroup (Charts, Fortune 500) announced that CEO Charles Prince had stepped down and that the bank could report up to $11 billion in mortgage-related losses in the fourth quarter.

On Wednesday, savings and loan Washington Mutual (Charts, Fortune 500) warned that the housing slump would last into 2008, investment bank Morgan Stanley (Charts, Fortune 500) announced it would take a $3.7 billion loss in its fiscal fourth quarter due to subprime exposure and insurer AIG (Charts, Fortune 500) reported lower-than-expected profits, partly due to debt-related investments that soured.

Bernanke said Thursday that estimates about financial institutions eventually losing $150 billion as a result of the subprime debacle were "in the ballpark."

The Dow Jones industrial average plummeted 361 points on Wednesday due to credit market fears - the fifth-largest decline this year. The Dow has fallen 4.5 percent in the past week.

And the market had a roller coaster day Thursday. Tech stocks took it on the chin but the Dow and S&P 500 rallied at the end of the day to pare their losses.

Speculation that China, a big holder of U.S. dollars, may reduce its exposure to the greenback in light of the dollar's weakness also has contributed to market volatility as of late.

But in the question-and-answer session, Bernanke said he was not concerned about any change in the currency investments of China or other countries for that matter.

In his testimony, Bernanke said that the Fed would "act as needed" in order to make sure that it can keep inflation under control as well as maintain "sustainable economic growth."

Other committee members urged Bernanke to cut rates in December, however.

Rep. Carolyn Maloney (D-N.Y.), the vice chair of the committee, said before Bernanke's testimony began that she did not believe inflation was a threat and noted the rise in the unemployment rate over the past few months.

And Sen. Sam Brownback (R-Kan.), a committee ranking member, said the economy is at a "crossroads" and that the Fed should cut rates in December to increase consumer confidence and spending ahead of the holidays.

But Weiss Research's Larson wondered if there is anything the Fed can do to keep the economy on track since a rate cut might make inflation worse while no rate cut might prolong the pain in housing.

"The Fed has to decide what is the lesser of two evils: helping the housing market or being tougher on inflation," Larson said. "The reality is dawning on investors that the Fed can't fix every problem facing the market." Top of page