Ben Bernanke's high-wire act

WASHINGTON (CNNMoney.com) -- For Federal Reserve Chairman Ben Bernanke, running the central bank has become an increasingly challenging high-wire balancing act.

All of Wall Street was watching the Fed chairman on Wednesday when he headed to Capitol Hill to outline the trio of challenges facing the Fed: an economy at risk of falling into a recession, topsy-turvy financial markets and the rising risk of inflation.

"We do face a difficult situation," Bernanke told members of the House Financial Services Committee, marking the first day of his two-day semi-annual hearing on the Fed's monetary policy. "The challenge for us is to balance those risks and decide at any given time which is more serious."

Bernanke's prepared testimony and his comments to lawmakers, however, stressed that the economy remained the central bank's primary concern saying that "downside risks to growth remain."

Markets initially turned higher following the release of his testimony as investors read signals that the Fed was prepared to continue cutting rates, if necessary, to stimulate the economy.

But Bernanke's comments were in line with the Fed's latest economic outlook and remarks he delivered alongside Treasury Secretary Henry Paulson before a Senate panel nearly two weeks ago.

At the time, the two policymakers warned of slower economic growth in the coming year but said they believed the U.S. economy would avoid tipping into a recession, helped in part by the $170 billion economic stimulus package signed by President Bush on Feb. 13 and the most recent interest rate cuts by the Federal Reserve.

"I don't think he broke a lot of new ground," said Scott Anderson, senior economist at Wells Fargo. "He stuck very close the Fed's forecast and outlook for the economy."

Among Bernanke's biggest concerns recently has been the embattled housing sector. On Wednesday he again said that he expected it to continue to weigh on economic activity in the months ahead.

"Homebuilders, still faced with abnormally high inventories of unsold homes, are likely to cut the pace of their building activity further, which will subtract from overall growth and reduce employment in residential construction and closely related industries," Bernanke said.

Fresh economic data seems to support the view that housing remains troubled. Sales of new homes fell to a nearly 13-year low in January, the Census Bureau reported Wednesday, just a day after a survey on residential real estate revealed that the decline in home prices picked up at the end of 2007

Eye on the consumer

One particularly important issue that the Fed chairman touched on Wednesday was the health of the consumer.

Bernanke acknowledged a significant slowdown in consumer spending as 2007 came to a close, and suggested that with home prices continuing to decline, a falling dollar and rising prices on a wide variety of consumer goods, the consumer could feel an even greater pinch.

"Any tendency of inflation expectations to become unmoored could reduce the flexibility of the [Fed] to counter shortfalls in growth in the future," he said. The Fed will continue to monitor inflation closely in the months ahead, he added.

Bernanke's remarks about inflation, however, marked a key divergence from his most recent remarks, noted Jane Caron, chief economic strategist at Dwight Asset Management, which manages about $70 billion in fixed-income assets.

"He did highlight that inflation pressures have increased," said Caron. "But as investors, is the Fed going to completely take their foot off the gas? How will they manage inflation risks?"

Perhaps the biggest inflation concern for Bernanke was high oil prices, which soared last year and continue to hover near record highs around $100 a barrel. While he said he did not expect such a similar increase in the price of crude during 2008, if oil prices did not moderate that could pose a serious problem for the U.S. economy, Bernanke said.

"If that happens, it will be a very tough situation," he said.

Bernanke also waded into the ongoing credit crisis, urging banks to continue to raise capital so they can continue to be able to lend and provide liquidity to the credit markets. A number of major U.S. financial institutions, for example, have been forced to look to large state-run foreign funds, or sovereign wealth funds, after suffering billions of dollars of losses.

The moves have raised protectionist fears on Capitol Hill, but Bernanke called the investments "constructive."

"I urge banks and financial institution to look to wherever they may find capitalization," Bernanke said.

Economy's warning signs

To help keep the economy from tipping into a recession, the Fed has steadily cut the federal funds rate, which affects a variety of consumer loans, since September. It slashed interest rates twice by 1.25 percentage points in just under a week last month.

Now the growing consensus among economists is that the Fed will cut interest rates by another half a percentage point when policymakers meet again on March 18 and possibly at least once more later this year.

But Bernanke stressed that the Fed would take the wait-and-see approach, saying that policymakers would carefully evaluate "incoming information on the economy outlook."

Plenty of economic reports are due out before the next Fed meeting, including next week's February employment report. The central bank will also get another reading on consumer inflation on March 14.

Lawmakers pressed Bernanke on what other actions he might consider if the economy were to worsen. He responded by suggesting that the central bank's current efforts - including the use of its "discount window" to make direct loans to commercial banks - are working.

"At the moment I'm satisfied with the general approach we are currently taking," said Bernanke.