By Neil Irwin
Washington Post Staff Writer
Friday, November 9, 2007

The economy is likely to slow through the first half of 2008, Federal Reserve Chairman Ben S. Bernanke said yesterday, as members of Congress called on him to take aggressive action to prevent a worsening mortgage crisis.

Even as he spoke to the Joint Economic Committee, more evidence emerged about just how widely the damage from the housing and financial markets could spread. Wal-Mart and Macy's reported October sales below their forecasts. Cisco Systems, a networking-equipment company that is considered a bellwether for the health of the technology industry, said sales dropped sharply because tighter credit markets have made companies reluctant to invest in technology. Tech stocks, one of the few bright spots in the market in recent weeks, tumbled.

The dollar continued its steep slide of recent months.

And Sotheby's stock fell 28 percent after a dismal auction of Impressionist paintings, where a Van Gogh failed to draw a single bid, sparking concern that lower bonuses on Wall Street will mean less demand for high-end art.

Bernanke told the committee he expects the economy to slow "noticeably" in the fourth quarter and remain sluggish in the first part of 2008. Sen. Charles E. Schumer (D-N.Y.), chairman of the Joint Economic Committee, said Bernanke should be more assertive in dealing with the millions of foreclosures expected in the next two years.

"I'm very concerned, Mr. Chairman, that none of the regulators, including the Federal Reserve, are acting quickly or boldly enough to deal with the risks we're facing," said Schumer, who generally has supported Bernanke. "A laissez-faire, hands-off attitude might be appropriate if we had any one of these crises alone. But, confronting all of these problems at once should be a call to action because the danger we face is so much greater."

Among other steps, Schumer said, Bernanke should move quickly on a series of regulatory policy changes to prevent banks from making irresponsible mortgage loans and use his stature to convince the Bush administration to provide federal money for nonprofit organizations that help people with mortgage problems.

Bernanke told lawmakers that Congress needs to take some steps of its own. In a rare specific recommendation on legislation, he urged Congress to pass a bill that would change Federal Housing Administration rules to help more low-income homeowners when their adjustable-rate mortgages reset to higher rates.

"In modernizing the FHA, the Congress might encourage joint efforts with the private sector that expedite the refinancing of subprime loans held by creditworthy borrowers facing resets," Bernanke said.

Legislation to adjust the FHA rules would increase the cap on the size of loans that the program insures and allow the agency more flexibility in deciding who can get insured loans. It has wide support in Congress and from the Bush administration, and has passed the House.

Bernanke elaborated on why the Fed last week cut short-term interest rates for the second time in two months, saying the risks that the housing downturn will slow the economy seemed greater than the risk of higher inflation.

"When you drive home on an icy road, you know that the most likely outcome is that you'll get home fine. But you still drive carefully, because there is a risk that you'll kill yourself," said Neal Soss, chief economist at Credit Suisse First Boston. "Bernanke is saying he needs to drive carefully. He expects that the economy will be okay, but there's a risk it won't, so it made sense to cut rates."

Bernanke acknowledged another set of risks with unusually specific language.

The rising price of oil and other commodities, and the simultaneous fall in the dollar, could ripple through the economy and create higher prices for a broader range of products. Such inflation would tie the Fed's hands if the economy weakens because if it cuts interest rates further, it could spur more inflation.

Bernanke said the higher oil prices and weaker dollar "were likely to increase overall inflation in the short run, and, should inflation expectations become unmoored, had the potential to boost inflation in the longer run as well."

By using tough, unambiguous words about the threat of inflation, Bernanke appeared to be signaling to financial markets not to count on more rate cuts anytime soon.

"He is trying to buy himself some flexibility," said John Silvia, chief economist at Wachovia. There was a widespread perception that investors, by counting on a rate cut last week, made the Fed more inclined than it would have been to grant it. "He doesn't want Wall Street forcing his hand again," said Silvia.

If that was Bernanke's plan, it didn't seem to work. After his pessimistic outlook for the economy, prices in futures markets yesterday indicated that investors' expectations rose for rate cuts at future meetings.

As Bernanke explained his expectation that the housing market would cease to be a drag on the overall economy by the middle of 2008, Sen. John E. Sununu (R-N.H.) noted that in March, he and Bernanke had disagreed on the housing outlook. Sununu recalled that he had expected housing inventories to rise more than the Fed chairman did.

"Well, Senator, you were right and I was wrong," Bernanke said yesterday. "Again, our anticipation . . . is that those inventories are not going to go much further from here. But, you know, in six months, you can tell me that I was wrong again."