Fed chief says recession may end in '09 if banking system shored up

WASHINGTON -- The economy is suffering a "severe contraction," Federal Reserve chairman Ben Bernanke told Congress on Tuesday. But he planted a glimmer of hope that the recession might end this year if the government managed to prop up the shaky banking system, and Wall Street rallied.

Bernanke said the economy is likely to keep shrinking in the first six months of this year after posting its worst slide in a quarter-century at the end of 2008.

Bernanke said he hoped the recession will end this year, but that there were significant risks to that forecast. Any economic turnaround will hinge on the success of the Fed and the Obama administration in getting credit and financial markets to operate more normally again.

"Only if that is the case, in my view there is a reasonable prospect that the current recession will end in 2009 and that 2010 will be a year of recovery," Bernanke told the Senate Banking Committee.

That -- along with the Fed chief's remarks that regulators don't intend to nationalize banks -- was enough to buoy Wall Street. The Dow Jones industrials added more than 236 points and the Standard & Poor's 500 index also rose, a day after both hit their lowest levels since 1997.

Among the risks to any recovery are if economic and financial troubles in other countries turn out to be worse than anticipated, which would hurt U.S. exports and further aggravate already fragile financial conditions in the United States.

Another concern is that the Fed and other Washington policymakers won't be able to break a cycle where disappearing jobs, tanking home values and shrinking nest eggs are forcing consumers to cut back sharply, worsening the economy's tailspin. In turn, battered companies lay off more people and cut back in other ways.

"To break that adverse feedback loop, it is essential that we continue to complement fiscal stimulus with strong government action to stabilize financial institutions and financial markets," Bernanke said.

In an effort to revive the economy, the Fed has slashed a key interest rate to an all-time low and Obama recently signed a $787 billion stimulus package of increased government spending and tax cuts.

In addition, Treasury Secretary Timothy Geithner has revamped a controversial $700 billion bank bailout program to include steps to partner with the private sector to buy rotten assets held by banks as well as expand government ownership stakes in them -- all with the hopes of freeing up lending. The Obama administration also will spend $75 billion to stem home foreclosures.

Those and other bold steps -- including a soon-to-be-operational program to boost the availability of consumer loans -- for autos, education, credit cards and other things -- should over time provide relief and promote an economic recovery, Bernanke said. That program is "about to open," he told lawmakers, without providing an exact date.

Sen. Christopher Dodd, D-Conn., chairman of the panel, and other senators suggested expanding that program overseen by the Fed and Treasury, to help squeezed local governments.

Radical actions by the government since last fall when the financial crisis intensified have relieved some credit and financial strains, Bernanke said.

"Nevertheless, despite these favorable developments, significant stresses persist in many markets," he said.

Although Bernanke didn't mention any financial institutions by name, Citigroup Inc. -- the industry's troubled titan -- apparently is in line for additional government help.

Sen. Bob Corker, R-Tenn., worried the government was "creeping" toward bank nationalization through a new option announced by the administration Monday. The new plan allows the government to greatly expand its ownership in a bank by converting preferred shares into common shares.

"It is not nationalization," Bernanke said.

Looking ahead, Corker was skeptical about the effectiveness of bank-rescue efforts saying he saw a continuation of "sort of dead-man walking, zombie bank."

Critics worry the Fed's actions have the potential to put ever-more taxpayers' dollars at risk and encourage "moral hazard," where companies feel more comfortable making high-stakes gambles because the government will rescue them.

The public's anger over the government's bailout efforts is understandable, the Fed chief said. "A lot of this goes against American values of self reliance and responsibility," Bernanke said.

Stress tests on the nation's biggest banks, which regulators will start conducting Wednesday, are designed to give regulators a better idea of how much additional capital and the type needed for banks to lend if the crisis were to grow worse than anticipated, Bernanke said. Regulators will assess banks' capital needs over a two-year horizon.

"The outcome of the stress test is not going to be fail or pass," he said, stressing that the goal is to return banks to health -- not take them over.

"We've always worked with banks to make sure that they're healthy and stable, and we're going to work with them. I don't see any reason to destroy the franchise value or to create the huge legal uncertainties of trying to formally nationalize the bank when it just isn't necessary," he said.

Separately Tuesday, the Fed issued a guidance letter that said banks need to be careful when they decide to pay dividends to shareholders that could raise "safety and soundness concerns."

The new guidance was intended for all banks the Fed regulates but was particularly aimed at banks "experiencing financial difficulties and/or receiving public funds." The letter said the bank holding company should inform the Fed if it is planning to pay a dividend that exceeds earnings for a given quarter or that could effect's the bank's capital position in an adverse way.

All the negative forces have battered consumers and businesses. "The economy is undergoing a severe contraction," Bernanke said.

The nation's unemployment rate is now at 7.6 percent, the highest in more than 16 years, and it will climb higher -- even in the best-case scenario that an economic recovery happens next year.

The Fed expects the jobless rate to rise to close to 9 percent this year, and probably remain above normal levels of around 5 percent into 2011. The recession, which started in December 2007, already has killed a net total of 3.6 million jobs.

Fed policymakers think that a "full recovery" of the economy is likely to take more than two or three years, Bernanke said.

To brace the economy, many analysts predict the Fed will leave its key rate at record lows through the rest of this year.