RISMEDIA

July 23, 2010

Shrugging off investors’ fears of a double-dip recession and punishing deflation, Federal Reserve Chairman Ben Bernanke predicted that a moderate U.S. economic expansion is likely to continue despite numerous threats to growth.

Testifying before the Senate Banking Committee, Bernanke acknowledged that European debt problems are slowing U.S. growth, as is the protracted slump in the U.S. housing sector. He said mounting federal budget deficits must be addressed, but added that government spending is warranted given the lack of private-sector demand for goods and services.

Bernanke shot down suggestions that his Fed is out of bullets should the economy slide back toward contraction.

“If the recovery seems to be faltering, then we at least need to review our options. We need to think about possibilities. But, broadly speaking, there are a number of things we could consider,” he said.

The Fed’s benchmark interest rates, a main lever of the central bank to spur economic activity, have been near zero for the past two years. That’s led some economists to worry that the Fed is running out of options to spark a slumping economy.

Bernanke countered that there are a number of unconventional steps the Fed still could take to stimulate the economy, ranging from resuming purchases of mortgages to reinvesting in securities to issuing a statement that interest rates will remain at zero for a fixed period to provide certainty to investors.

“We have not come to the point where we can tell you precisely what the leading options are,” he said, adding that “policy is already quite stimulative. I think we still do have options, but they are not going to be the conventional options.”

Bernanke was blunt about the challenges, and he acknowledged that some government stimulus that powered the expansion in the first half of 2010 is likely to fade.

“Although fiscal policy and inventory restocking will likely be providing less impetus to the recovery than they have in recent quarters, rising demand from households and businesses should help sustain growth,” Bernanke said in opening remarks.

He later discounted, when asked directly, the chances of sliding back into recession.

“Our expectation is still for a moderate recovery which will over time bring down the unemployment rate. That’s still our main scenario, that the economy will continue to grow and that private demand will take over as the driver of growth,” he said.

Financial markets slumped shortly after Bernanke’s testimony was made public, in part because of his acknowledgement that “the economic outlook remains unusually uncertain,” but the thrust of what he said was positive.

Real consumer spending appears to have expanded at about a 2.5% annual rate in the first half of 2010, Bernanke said, with purchases of durable goods—such as large appliances—increasing especially rapidly.

The economic forecast of the Fed’s Open Market Committee (FOMC), which sets the benchmark lending rate that influences borrowing costs across the economy, remains mostly unchanged, he said. Most FOMC members expect the economy to grow at a rate of 3-3.5% this year and 3.5-4.5% in 2011 and 2012, and they anticipate a jobless rate of 7-7.5% by late 2012.

Not everyone agrees with the Fed’s assessment.

“This forecast looks a bit optimistic. Our own outlook calls for growth of 2.4% in 2010 and 2.5% growth next year,” Mark Vitner, senior economist with Wells Fargo Securities in Charlotte, N.C., wrote in a research note to investors after Bernanke’s testimony.

What Bernanke didn’t say was also noteworthy. There was no mention of the threat of deflation, a fall in prices across the economy.

Deflation leads businesses and consumers to hoard cash on the assumption that prices will be lower soon, and growth skids. The word deflation doesn’t appear anywhere in Bernanke’s 56-page Monetary Policy Report to Congress, either.

Yet some prominent economists fear that the United States is nearing a deflationary cycle like the one now in Japan. They point to core inflation, which strips out volatile food and energy prices. Through June, it was running at a year-over-year rate of 0.9%, the lowest increase since 1966. That’s below the Fed’s target rate of 1-2%.

“Bernanke has thought long and hard about how to avoid a Japanese-style economic trap, and the Fed’s researchers have been obsessed for years with the same question. But here we are, visibly sliding toward deflation—and the Fed is standing pat,” columnist Paul Krugman, a Nobel Prize-winning liberal economist, wrote recently.

Krugman’s concerns are shared by John Makin, a highly-regarded analyst at the conservative American Enterprise Institute, a research center. Makin fears that consumers and businesses may begin sitting on cash because it gains purchasing power as prices fall.

“The desire to hold cash is a dangerous part of the deflation psychology,” he warned, noting that deflation often accompanies a financial crisis.

Near the end of his lengthy testimony, Bernanke was asked directly about deflation and he discounted the threat.

“Forecasts are very uncertain, but I don’t view deflation as a near-term risk for the United States,” he said, noting that the Fed would be “assiduous” should deflation emerge. As the economy picks up steam, inflation will start ticking back toward the 2% range, Bernanke said.