Fed's Bernanke Defends Bear Stearns Bailout, Paints Glum Economic Picture

Wednesday, Federal Reserve Chairman Ben Bernanke touched on a variety of factors contributing to the current weak state of the U.S. economy, but also defended the Fed's recent actions to facilitate a deal that prevented a major investment bank from collapsing.

Testifying before the congressional Joint Economic Committee, Bernanke said the Bear Stearns bailout would normally not have been a matter for Fed involvement except that the company was widely interconnected to many areas of "critical" markets.

Normally, he said, the market sorts out which companies survive or fail, but the news of an imminent Bear collapse "raised difficult questions of public policy."

Bernanke also noted that the risks to the economy remain to the downside and "inflation has also been a source of concern."

"With financial conditions fragile, the sudden failure of Bear Stearns likely would have led to a chaotic unwinding of positions in those markets and could have severely shaken confidence," Bernanke said. "Given the current exceptional pressures on the global economy and financial system, the damage caused by a default by Bear Stearns could have been severe and extremely difficult to contain."

The collapse would have affected financial markets, as well as the broader economy, by depressing a wide range of asset values and further restricting the already tight supply of credit.

He said that several measures taken by the Fed to encourage inter-bank lending, thereby broadly improving the availability of new lines of credit to both investors and consumers, have to date been "helpful" in addressing some of the strains in financial markets.

Bernanke addressed widespread commentary by Fed critics that the central bank may be overextending its bottom line by making credit available to more institutions than ever before, including the 20 investment bank primary dealers. He said the Fed is "working closely with the Securities and Exchange Commission to monitor the financial conditions and funding positions of primary dealers who might seek Federal Reserve credit."

However, the combination of falling home prices, a pickup in inflation related to higher energy and food prices, lower demand for labour and lower real disposable income present real challenges for the economy, he said. He noted it appears likely that real gross domestic product will not grow much at all over the first half of the year, and could even contract.

Even the forecast of growth in 2009 is challenged by current economic conditions, he said.

"In light of the recent turbulence in financial markets, the uncertainty attending this forecast is quite high and the risks remain to the downside," Bernanke said.

Two small positives exist, he pointed out, namely that the non-financial business sector remains "sound" and that many businesses are "enjoying strong demand from abroad," due largely in part to better exports because of a weak dollar. Bernanke also added he expected a financial stimulus package passed by Congress earlier in the year to boost consumer spending in coming quarters.

The Fed's other response to economic weakness, aggressive cutting of interest rates in the past several months, should also help promote growth over time and mitigate risks to economic activity, he added.

"Clearly, the U.S. economy is going through a very difficult period," Bernanke said. "But among the great strengths of our economy is its ability to adapt and to respond to such diverse challenges. I remain confident in our economy's long-term prospects."

Bernanke noted that although "inflation will moderate in the coming quarters" it remains "a source of concern" for the Fed. He pointed out that the personal consumption expenditures (PCE) price index for the past 12 months rose to 3.4% from 2.3% over the preceding 12 months.

This pick-up in inflation has resulted from "sharp increases in the prices of crude oil, agricultural products, and other globally traded commodities" and the weak dollar, he said.

Inflation will moderate as the demand for commodities lessens as global growth slows and resource utilization pressures ease, Bernanke said.

By Michelle Zimmermann, edited by Steve Campbell, Stephen Huebl and Cristina Markham