By Neil Irwin
Washington Post Staff Writer
Friday, February 15, 2008
The economy is likely to improve in the second half of the year after a slow start, Federal Reserve Chairman Ben S. Bernanke said yesterday. But he also signaled that the central bank is open to further interest rate cuts because of the risk that the situation will get worse.
Bernanke, in testimony to the Senate Banking Committee, was trying to strike a tricky balance. He and Treasury Secretary Henry M. Paulson Jr., who also testified, each aimed to show they were responding aggressively to risks to the financial markets and the economy, while not indicating a sense of panic that might make the situation worse.
"My baseline outlook involves a period of sluggish growth, followed by a somewhat stronger pace of growth starting later this year as the effects of monetary and fiscal stimulus kick in," Bernanke said. He added that risks remain, including the risk that the housing market or job market could get even worse than he forecasts, or that credit conditions could tighten further.
That reserved tone and relative optimism about the economy appeared to annoy Democrats and some Republicans on the committee, who suggested that Bernanke and Paulson are responding too timidly to the economic slowdown and mortgage crisis.
"The administration, including the agencies represented here this morning, need to do more . . . much more," said Banking Committee Chairman Christopher J. Dodd (D-Conn.).
Even as he projected that the economy will continue to grow this year, if slowly, Bernanke gave several clues that the Fed is inclined to cut interest rates beyond the 2.25 percentage points it has reduced a key short-term interest rate since September.
Bernanke said the central bank will act as needed to support growth and "to provide adequate insurance" against downside risk. He also indicated that he expects inflation to moderate. Futures markets now price in a near-certainty that the Fed will cut the federal funds rate, at which banks lend to each other, by at least another half-percentage point on or by its March 18 meeting.
"He wants the market to be aware that while the Fed is worried and will continue to ease, it's not an open-ended commitment," said Bruce Kasman, chief economist at J.P. Morgan Chase. "It's saying we are worried about downside risks, but we've also done a lot already."
There was some evidence yesterday that the nation's export sector is becoming a source of strength, as the trade deficit fell to $58.8 billion in December from $63.1 billion in November. The stock market was down for the day nonetheless, after strong gains earlier in the week, with the Dow Jones industrial average off 175 points, or 1.4 percent.
Senators were particularly concerned about the breakdown in the market for a little-known form of debt called "auction-rate securities," which has caused trouble for some educational institutions and municipalities. The problems in that market recently caused the Port Authority of New York and New Jersey to see its interest rate on $100 million in debt rise to 20 percent from 4.2 percent.
Bernanke and Paulson stressed that these problems are different from those of the subprime mortgage market, in that the underlying quality of the debt remains strong.
"With respect to municipal bonds and student loans, the good news is that the underlying quality of those credits is generally very good," said Bernanke. No one is really thinking that the Port Authority's credit quality is any worse than before, he said.
Paulson emphasized that what investors truly fear in this crisis is complexity in financial products, and that an ongoing reversal of risks is occurring.
"What we're seeing is, although it was subprime that maybe produced the spark that got this going, that we had a dry forest out there," Paulson said. "Investors reached for yield and mispriced risk in a number of markets. And so now what you're seeing is a reaction, and the areas of the market that are under the most stress today are those that are the most complex products."
Securities and Exchange Commission Chairman Christopher Cox, who also testified at the hearing, said his agency is examining credit-rating companies, whose ratings of mortgage-related securities played a role in the current problems.
Some senators interpreted Bernanke's and Paulson's comments to mean they are waiting for the problems in credit and mortgage markets to work themselves out.
"The clock is ticking much faster," said Sen. Jack Reed (D-R.I.). "Which puts, I think, huge pressure on not simply letting the market work it out, but to take a much more deliberate, much more focused, much more concentrated action, because at some point the American people will demand it even more affirmatively than they are today."
That tension resulted in some testy exchanges.
Sen. Robert Menendez (D-N.J.), for example, ticked off a list of dour news items that suggest the economy is slowing, saying, "I don't want to talk down the economy, but at the same time, we need to be able to work to build it up if we know we have challenges."
"If you are trying to talk the economy up, I'd hate to see you try to talk it down," Paulson said.
"I'm not trying to hide my head in the sand either," Menendez responded.
Sen. Bob Corker (R-Tenn.) pushed Paulson to specify whether he believes the problems in financial markets amount to a correction, or a crisis.
"I don't use loaded words," Paulson said, "And so I've been using 'correction' because it is a correction."