Bernanke: Economic outlook weaker

Fed chairman says financial crisis will dampen economy well into 2009 and hints at future rate cuts; says recent actions by Fed, Treasury should help economy recover.

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By Chris Isidore, CNNMoney.com senior writer

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NEW YORK (CNNMoney.com) -- Federal Reserve Chairman Ben Bernanke predicted that the global financial markets crisis is likely to restrain the economy well into next year and signaled that the Fed may be getting ready to cut interest rates.

But he said he believes the unprecedented steps taken to have the Treasury Department and the Fed intervene in financial markets were done in time to prevent more expensive and permanent damage to the nation's leading financial institutions.

In a speech before the National Association of Business Economics in Washington on Tuesday, Bernanke said the threat of inflation has receded recently, while the economy has continued to weaken. This could be interpreted as a sign that the central bank might be preparing to lower its key fed funds rate soon.

"Overall, the combination of the incoming data and recent financial developments suggests that the outlook for economic growth has worsened and that the downside risks to growth have increased," he said.

"In light of these developments, the Federal Reserve will need to consider whether the current stance of policy remains appropriate," he added.

The fed funds rate is the primary lever the central bank uses to influence the economy. Lower rates can help reduce the borrowing costs for businesses and consumers on a wide range of loans, including business lines of credit, credit card rates and home equity loans. These cheaper loans can increase economic activity.

But lower rates can also add to inflation pressures since they tend to reduce the value of the dollar and make imported goods, most notably oil, more expensive.

The Fed cut rates seven times between September 2007 and this April, but held them steady at 2% at its past three meetings due to inflation concerns.

The Fed's next scheduled meeting is Oct. 28-29. Some investors and economists have suggested the current financial crisis could lead the Fed to announce an emergency rate cut ahead of that meeting.

Inflation worries begin to subside

Bernanke again pointed to falling housing prices as a primary cause of the problems in the nation's financial sector. But he warned "the slowdown in economic activity has spread outside the housing sector."

And he added that tighter credit conditions mean that the economic weakness is likely to continue into 2009.

"The heightened financial turmoil that we have experienced of late may well lengthen the period of weak economic performance," he said.

During the question and answer period following the speech, Bernanke reiterated that pricing pressures have been reduced but warned that "we have to be careful not to declare victory" regarding inflation just yet.

Nonetheless, several economists said Bernanke's comments seemed to signal the Fed now was pointing towards a rate cut sooner rather than later.

"I'm sure the inflation hawks are worried," said John Silvia, chief economist at Wachovia, referring to economists and Fed policymakers who are generally more worried about inflation pressures. "But I think they'll give Ben enough of a leash."

Gus Faucher, director of macroeconomics at Moody's Economy.com, said he agreed with Bernanke that the economy would likely remain weak for some time and that the Fed will probably lower rates to minimize the economic pain.

"I don't think there's anything we can do to avoid that at this point," he said. "What they'll be trying to do [with a rate cut] is make sure things aren't worse, that the weakness isn't deeper and doesn't last longer."

Minutes of the Fed's most recent meeting on Sept. 16, which were released shortly after Bernanke finished speaking, showed that a rate cut was a topic of discussion even at that time.

"Some members emphasized that if intensifying financial strains led to a significant worsening of the growth outlook, a policy response could be required," the minutes said.

But members agreed a rate cut wasn't called for at that time. In addition, inflation remained enough of a concern that some members were still looking for a rate hike at some undefined point in the future.

Defending the bailout

In his speech, Bernanke defended the $700 billion bailout package passed by Congress and signed into law last week. The rescue plan will allow Treasury to buy damaged mortgage-backed securities from financial firms.

Bernanke said the bailout, as well as moves by the Fed this week to inject hundreds of billions more into the banking system and buy commercial paper used by many businesses to finance their day-to-day operations, were necessary actions to take at this time of economic stress.

"These are momentous steps, but they are being taken to address a problem of historic dimensions," he said.

And he predicted that the efforts would be successful in returning the economy into a growth path.

"The steps being taken now to restore confidence in our institutions and markets will go far to resolving the current dislocations in the markets," he predicted. "I believe that the bold actions taken...together with the natural recuperative powers of the financial markets, will lay the groundwork for financial and economic recovery." To top of page

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