Bernanke: Economy Faces Dire Risk From Fiscal Cliff

Catherine Hollander

Federal Reserve Board Chairman Ben Bernanke delivered a bleak assessment of the U.S. economy on Tuesday, warning of dire risks surrounding the approaching fiscal cliff.

The Fed chief used his semiannual economic testimony to put lawmakers on notice that a failure to resolve differences over taxes and spending by the end of the year could pose grave harm to an already struggling recovery.

“U.S. fiscal policies are on an unsustainable path, and the development of a credible medium-term plan for controlling deficits should be a high priority,” he told the Senate Banking Committee in the first leg of two-day testimony. “At the same time, fiscal decisions should take into account the fragility of the recovery.”

Bernanke said that the economy had clearly lost momentum in the first half of the year and faced further risks from the crisis in Europe. He was noncommittal about whether the central bank was close to embarking on a third round of bond-buying, known as quantitative easing, to boost the recovery. Still, his downbeat economic assessment reinforced expectations that the Fed could act soon absent some unexpectedly encouraging data. Bernanke continued to cite QE3 as one of many tools left in a kit that includes other types of purchase programs, communication of future balance-sheet plans, and reductions in interest rates.

The Fed chairman was also grilled about the scandal surrounding a benchmark interest rate known as Libor. Bernanke called the matter “very troubling” and said that it had the potential to undermine confidence in the financial markets. He also defended the response of the New York Fed, which is the central bank’s arm in financial markets, saying there was "rapid followup" by bank officials when they learned of potential rate manipulation in 2008.

The tempest involving U.K.-based Barclays is the latest in a series of bank scandals over the past year, including the collapse of brokerage firm MF Global and missing customer money in the fall and JPMorgan Chase’s massive trading losses last spring. The fallout is expected to grow as regulators probe other banks for similar wrongdoing and as lawmakers push forward with investigations.

Sketching out his predictions for the economy, Bernanke ticked off indicators, one by one, that have signaled a slowing in coming months. According to the Fed chairman, real gross domestic product is expected to grow at less than a 2 percent annual rate in the second quarter of 2012 after expanding by 2 percent in the first quarter. Household spending is likely to slow. Although there have been “modest” signs of improvement, progress in the housing market is stymied by worries about the economy and tight lending standards. Investment demand appears likely to remain weak. The unemployment rate will probably remain at 7 percent or higher at the end of 2014. Economic growth will pick up only “very gradually.”

The outlook was much gloomier than Bernanke put forward in his previous semiannual testimony, delivered in February. Then, he told lawmakers that the Fed had seen positive developments in the labor market, an advance in household spending, a rebound in consumer sentiment, and gains in manufacturing production. The good news came with caveats, but was on the whole more positive than the assessment the Fed chief put out on Tuesday.

Now, Bernanke says members of the FOMC are even more uncertain about their forecasts than usual, and that the risks to growth are higher.

The nation's fiscal situation is one of the primary sources of that risk. Bernanke has warned lawmakers repeatedly that their failure to stop the combination of tax increases and spending cuts that are set to occur at the end of the year, known as the “fiscal cliff,” will hurt the economy. On Tuesday, he emphasized the tightrope lawmakers must walk.

His testimony comes as Democrats have signaled they believe they will have the upper hand in the standoff and have indicated a willingness to allow the tax cuts to expire to pressure Republicans into accepting a deal that would renew tax breaks for the middle class but allow taxes for the wealthiest to rise.

A Congressional Budget Office prediction that going over the fiscal cliff would cause a shallow recession in 2013 probably doesn’t do justice to the economic damage, according to the Fed chairman, because it doesn’t incorporate the effects of public uncertainty surrounding how the matters will be resolved.

Europe is the other major source of risk. Even though the Fed is working closely with its European counterparts and U.S. banks have better capital and liquidity positions than they did just a few years ago, Bernanke warned that an escalation of the eurozone sovereign-debt crisis that disrupts global financial markets would “inevitably” be a challenge for the U.S. financial system and economy.

Senate Banking Committee Chairman Tim Johnson, D-S.D., used the European interest-rate scandal as a springboard to talk about the role of financial regulation. “Recent events such as the CFTC [Commodity Futures Trading Commission] ordering Barclays to pay a $200 million penalty for Libor manipulation are reminders that we need tough, fair rules in place – and strong, adequately funded financial regulators to enforce those rules,” he said.

Much is unknown about the scope and impact of rate-rigging during the financial crisis. Last month, Barclays reached a settlement with U.S. and U.K. regulators over a probe into its manipulation of the rate. Much is likewise unknown about U.S. regulators’ response to the scandal, and senators zeroed in on that question at Tuesday's hearing. Bernanke filled in some details about the role of the Fed's Board of Governors--including telling the senators that he himself first learned of possible manipulation of borrowing costs in April 2008 through the media, not through the central bank's internal channels.

Bernanke said that Libor, which is based on self-reporting by banks, was “structurally flawed” in its current form. Asked by Sen. Jack Reed , D-R.I., if Bernanke could assure Americans that Libor is reliable and the changes recommended by the New York Fed in 2008 were put in place, Bernanke said he couldn’t give that assurance “with full confidence” as most of the reforms weren’t adopted by the British Bankers’ Association, which oversees the rate.