The Fed to the rescue

Federal Reserve Chairman Ben Bernanke painted a bleak picture of the U.S. economy Thursday and said the central bank is ready to cut interest rates again.

NEW YORK (CNNMoney.com) -- Federal Reserve Chairman Ben Bernanke said in a speech Thursday that the central bank is prepared to continue lowering interest rates in order to help keep the economy on track.

He also reiterated that the Fed does not believe the economy will slip into a recession this year.

"We stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks," Bernanke said in prepared remarks before the Women in Housing and Finance and Exchequer Club in Washington, D.C.

However, some economists suggested that rate cuts may be too late to stop a recession. But stocks, which had been trading lower before the speech, rebounded modestly in the afternoon and soared following reports that Bank of America (BAC, Fortune 500) was in talks to buy embattled mortgage lender Countrywide Financial (CFC, Fortune 500).

Wall Street interpreted Bernanke's comments to mean that there is now an increased likelihood the Fed will lower its key federal funds rate by a half percentage point, to 3.75 percent, at the conclusion of its two-day meeting on Jan. 30.

"A half-point cut is certainly on the table and it's about time. The Fed has a lot of work to do," said James Glassman, senior economist with JPMorgan Chase.

To that end, investors are pricing in a 92 percent chance that the Fed will lower rates by a half-point on Jan. 30, according to federal funds futures listed on the Chicago Board of Trade.

"The Fed has changed course. It has moved from a limited loosening mode designed to mitigate the impact on the financial markets to more aggressive loosening aimed at stimulating growth," said Chris Probyn, chief economist with State Street Global Advisors in Boston.

Probyn said he expects a half-point cut later this month followed by a quarter-point cut at its next meeting in March and did not rule out further cuts at meetings in April and June as well.

But Bernanke's speech comes as more and more economists are saying that the economy is either already in a recession or on its way toward entering one. Bernanke stopped short of describing current conditions as a recession in his prepared remarks but he did paint a bleak picture for the economy in 2008.

"Downside risks to growth have become more pronounced. Notably, the demand for housing seems to have weakened further, in part reflecting the ongoing problems in mortgage markets," Bernanke said.

"In addition, a number of factors, including higher oil prices, lower equity prices, and softening home values, seem likely to weigh on consumer spending as we move into 2008," he added.

During a question-and-answer session, Bernanke said the Fed is not currently forecasting a recession in 2008. Instead, he said the Fed expects growth to slow.

He added though, that it is difficult to make a determination about whether an economy is in recession until after the fact.

Probyn agreed. And he said that if the economy is already in a recession or close to one, a rate cut later this month would be too little, too late. The best the Fed can do now is to take steps to ensure that the recession does not last long.

"If we do have a recession, it would be quite mild and probably in the first half of the year. Nothing the Fed does today can do anything about that," Probyn said. "But rate cuts may stimulate growth by late summer and into the end of the year."

Glassman, however, said that the Fed may have waited far too long to cut rates aggressively and that even if the economy doesn't dip into a recession, there could be a prolonged slump since the job market has weakened in a relatively short period of time.

"When you have to step up the pace of easing and you're doing it after unemployment has been rising, you're not exactly ahead of the curve," he said.

Bernanke discussed inflation as well, but he said that "inflation expectations appear to have remained reasonably well anchored," and suggested that rising oil and food prices "may be a negative influence on growth" in addition to putting pressure on inflation measures.

That comment appears to give more evidence to those who think the Fed is now more concerned about a recession than rampant inflation.

"Obviously, inflation is a concern but for the Fed, you're better off front-end loading rate cuts now," said John Derrick, director of research with U.S. Global Investors Inc, a money management firm based in San Antonio. "If you have to take them back later and raise rates to deal with inflation, you deal with that then."

As such, some market strategists and economists have even suggested in the past few days that the Fed could cut rates in an unscheduled meeting before January 30.

Bernanke did not comment in his remarks about whether a rate cut before Jan. 30 was possible. But he did say that the Fed "must remain exceptionally alert and flexible, prepared to act in a decisive and timely manner and, in particular, to counter any adverse dynamics that might threaten economic or financial stability."

Bernanke also said the central bank's new auction program, which it announced in December as a way to loan money to banks in need of cash at a rate below the Fed's discount rate, appears to be a success and could "become a useful permanent addition to the Fed's toolbox."

The Fed has already conducted two auctions for a combined $40 billion and will be loaning $60 billion more later this month through two additional auctions.