Paulson, Bernanke: Slow growth ahead

Treasury Secretary Henry Paulson, left, and Fed Chairman Ben Bernanke believe the U.S. will avoid a recession.

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NEW YORK (CNNMoney.com) -- Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson both acknowledged problems in the U.S. economy Thursday, but both said they believe the nation will avoid falling into recession.

The two made their comments at a hearing before the Senate Banking Committee about the economy. Their testimony comes in the wake of troubling economic readings that have raised recession fears on Wall Street.

But while Paulson and Bernanke repeatedly insisted they expect the economy to avoid shifting into reverse - thanks in part to a series of interest rate cuts by the Fed and a $170 billion economic stimulus package signed by President Bush Wednesday - they conceded the economy faces additional headwinds.

Bernanke and Paulson both said the outlook for the economy is noticeably worse than it was as recently as a few months ago, and both expect cuts in official growth forecasts from the administration and the Fed in upcoming months.

The Fed is currently predicting 1.8% growth for this year, but Bernanke said a new forecast would be finalized next week. The Council of Economic Advisors' most recent estimate was for the economy to grow by 2.7% in 2008.

More losses, tight credit ahead

Bernanke said he believes major banks and Wall Street firms are likely to take additional earnings hits tied to bad investments in subprime mortgages. That could lead to tighter lending standards and contribute to an overall slowdown.

"More expensive and less available credit seems likely to continue to be a source of restraint on economic growth," Bernanke said.

But he added he's not worried about bank failures because he thinks banks entered the current downturn with sufficient capital and have been able to raise additional funds.

Some of the panel members praised the two for the steps taken so far to spur the economy.

The Fed last month made two significant interest rate cuts: three-quarters of a percentage point at an emergency meeting, followed by half a point eight days later.

Bernanke said Thursday that the Federal Open Market Committee, its rate-setting body, was ready to act again if further economic readings justify it.

But some senators criticized the pair, suggesting the administration and the central bank are at least partly to blame for the current economic problems, due to lax oversight and lack of early response to the downturn in housing.

Sen. Charles Schumer, D-N.Y., suggested the problems in credit and financial markets pose a greater threat to the economy than a slowdown in consumer spending.

"Aren't you underestimating, not giving enough attention to, the severity of the problem in the credit markets?" asked Schumer. He said Wall Street executives he's talked to "seem much more worried" about credit woes than Paulson and Bernanke.

Paulson, a former CEO of Goldman Sachs (GS, Fortune 500), responded that he also spoke regularly with top Wall Street executives, adding "some are more worried than others."

Paulson on defensive

Sen. Robert Menendez, D-N.J., pointed out that Goldman Sachs is one of the growing number of investment banks forecasting a recession this year and suggested that Paulson and Bernanke "hit the snooze button" when alarm bells about the economy first went off last year.

Menendez said he wasn't trying to talk down the economy, but that he was looking for "honest assessments" from Paulson.

Paulson bristled at the comments, telling Menendez, "If you're trying to talk the economy up, I'd hate to see you talk it down."

Menendez shot back, "I'm just trying not to hide my head in the sand."

"I'm not either," responded the Treasury Secretary.

The two also were asked to explain why investments in many major banks and Wall Street firms by sovereign wealth funds should not be a concern.

Sovereign wealth funds - large pools of money controlled by foreign countries - have taken stakes in recent months in Citigroup (C, Fortune 500), Merrill Lynch (MER, Fortune 500) and Morgan Stanley (MS, Fortune 500).

Paulson said these investments are an important endorsement of the U.S. financial system and that they do not pose a risk of foreign governments having undue influence on major banks here.

"I think we need to be vigilant. I don't think we need to be fearful," said Paulson.

Paulson says economy 'fundamentally strong'

Throughout the hearing, Paulson and Bernanke repeated that they expect slower growth and not a recession.

Paulson said the economy "is fundamentally strong, diverse and resilient" and that the main problem is that it is "undergoing a significant and necessary housing correction."

But Senate Banking Chairman Christopher Dodd, D-Conn., said the slowdown is due to a crisis of confidence among both consumers and investors.

Dodd was critical of some of the Bush administration's housing efforts, including the freeze on foreclosures announced this week by Paulson and some of the country's leading mortgage lenders.

"It is a lifeline more to lenders than to borrowers in my view," said Dodd.

Sen. Richard Shelby of Alabama, the ranking Republican on the committee, said he's concerned that the mortgage meltdown is spreading to the rest of the economy.

"One thing that is now clear to all of us is the subprime mortgage problems are not contained," said Shelby.

He added that he doubts whether the stimulus package would prove to be effective.

"Even if every consumer spends their $600 tax rebate, I've equated it to pouring a glass of water in the ocean and expecting it to make a difference," Shelby said. "I hope I'm wrong."