Bernanke: Fed ready to act if economy worsens

WASHINGTON -- Federal Reserve chairman Ben Bernanke told lawmakers Wednesday the Fed is ready to act if the economy gets weaker. He warned them that allowing the nation to default on its debt would send "shock waves through the entire financial system."

Underscoring how fragile the economy remains two years after the recession, Bernanke laid out three new steps the Fed could take, including a fresh round of government bond purchases designed to stimulate economic growth.

"We have to keep all the options on the table. We don't know where the economy is going to go," Bernanke told the House Financial Services Committee.

Bernanke stopped short of promising anything, but Wall Street appeared comforted that the central bank was poised to act. The Dow Jones industrial average was up more than 150 points during his testimony to Congress, and closed up 45.

The nation was creating about 200,000 jobs a month this spring. But hiring slowed almost to a standstill in June, with 18,000 new jobs. It takes about 125,000 a month just to keep up with population growth.

While Bernanke made his twice-yearly appearance before Congress, lawmakers and the White House were trying to salvage talks on how to reduce the federal deficit and whether to raise the limit on what the government can borrow.

If they fail to strike a deal on the debt limit by Aug. 2, the White House has said, the nation will default.

Moody's Investors Service threatened Wednesday to lower the United States' credit rating, saying there is a small but rising risk of default. Economists have warned that the credit system would tighten, not unlike the worst days of the 2008 financial crisis. Before Congress, Bernanke added his own dire predictions.

"If we went so far as to default on the debt, it would be a major crisis because the Treasury security is viewed as the safest and most liquid security in the world," he said.

"It's the foundation for most of our financial -- for much of our financial system," he added. "And the notion that it would become suddenly unreliable and illiquid would throw shock waves through the entire global financial system."

Asked whether interest rates would go up for everyday Americans, Bernanke said: "Absolutely."

The Fed bought $600 billion in government bonds late last year and early this year, a program designed to keep interest rates low and support the prices of assets such as stocks.

It was the second time the Fed had taken that step since the recession started. It was known on Wall Street as "QE2," or a second round of "quantitative easing." Besides a third round, Bernanke laid out two additional options if the economy gets weaker:

-- The Fed could offer financial markets more clarity about how long it tends to leave interest rates at record lows, where they have stood since December 2008. For now, the Fed says only that rates will remain "exceptionally low" for an "extended period."

-- It could start paying banks less interest on the excess money they park with the Fed. It doesn't pay much now -- 0.25 percent. But paying even less would encourage the banks to loan the money out rather than sending it to the central bank.

Bernanke said the measures would be necessary only if deflation, a cycle of falling prices that damages the economy, became a threat. For now, prices are still rising. Some inflation is healthy, economists say.

Critics of the Fed's two previous rounds of "quantitative easing" have said the real threat is the opposite -- that the central bank will create runaway inflation by flooding the economy with money.

Bernanke said the Fed was ready to raise interest rates if inflation becomes a serious threat.

The Fed has said that temporary factors, such as high gas prices and manufacturing disruptions caused by the earthquake and tsunami in Japan, are partly to blame for the economy's sudden sluggishness.

Bernanke told Congress that the Fed believes those impediments should ease in the second half of the year.

Laying out the three options was "a very generic statement, rather than a specific commitment to doing this," said Michael Hanson, senior economist at Bank of America. He said Bernanke was trying to "comfort people that the Fed is ready to act if needed."

Paul Ashworth, chief U.S. economist at Capital Economics, said any decision on Fed action probably wouldn't happen until next year.

The last time the Fed bought up Treasury bonds, Bernanke laid out the plans in a speech Aug. 27, 2010. The Dow stood at about 10,000 at the time and rallied to higher than 12,800 this spring before pulling back. It closed Wednesday at 12,491.

"The market's reaction reflects Bernanke's message that either the economy will reaccelerate or the Fed will step in again," said Jim O'Sullivan, chief economist at MF Global, a brokerage.

At least at first, the market appeared to treat Bernanke's comments before Congress as a similar moment to his August 2010 speech, delivered in Jackson Hole, Wyo., said Joe Saluzzi, co-head of equity trading at Themis Trading in Chatham, N.J.

"It's just silliness, in my opinion," he said. "There's nothing new here. But the bulls are taking this as, `This is fantastic."'

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AP Economics Writer Christopher S. Rugaber in Washington and AP Business Writers Matthew Craft and David K. Randall in New York contributed to this report.