Bernanke warns of dire risk from fiscal cliff inaction

Federal Reserve Chairman Ben Bernanke delivered one of his bleakest assessments of the U.S. economy on Tuesday, warning of dire risks surrounding the approaching fiscal cliff.

In testimony prepared for a semiannual Senate Banking Committee  hearing, the Fed chief 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 weak U.S. economy.

“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 said. “At the same time, fiscal decisions should take into account the fragility of the recovery.”

He cited a slow-down in economic activity in the first half of the year and growing risks to the U.S. recovery from Europe. He did not say in his testimony whether the central bank was close to embarking on a third round of bond-buying, known as quantitative easing, to boost the recovery.

Bernanke ticked off economic indicators, one by one, each likely to slow in coming months. According to the Fed chairman, real GDP 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 economic assessment 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 the risks to growth higher.

The U.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, also known as the “fiscal cliff,” will hurt the economy. On Tuesday, he emphasized the tightrope lawmakers must walk.

A Congressional Budget Office estimate that going over the fiscal cliff would cause a shallow recession in 2013 probably doesn’t do the economic damage justice, 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 euro-zone sovereign debt crisis that disrupts global financial markets would “inevitably” be a challenge for the U.S. financial system and economy.

The Fed chairman offered no hints of quantitative easing in his testimony, only repeating the Fed’s oft-sounded refrain that the bank “is prepared to take further action as appropriate.” Lawmakers are expected to press Bernanke on when, exactly, such action might be appropriate.

Bernanke also did not mention the recent scandal surrounding the possible rigging of a global benchmark rate known as Libor in his opening remarks, but lawmakers will likely question the regulator on what he knew about the potential rate-rigging, and when. Senate Banking Committee Chairman Tim Johnson, D-S.D., used the scandal as a springboard to talk about the role of financial regulation in his opening remarks.

“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.

Members of the Banking Committee are also likely to question Bernanke on Dodd-Frank implementation. The financial reform law’s two-year anniversary is Saturday, and regulators are still writing many of the rules.