Bernanke Sees `Grave Threats' to Financial Stability

By Craig Torres

Sept. 24 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke said the U.S. is facing ``grave threats'' to financial stability and warned that the credit crisis has started to damage household and business spending.

``Economic activity appears to have decelerated broadly,'' Bernanke said today to a congressional Joint Economic Committee hearing, downgrading the assessment of Fed officials when they met on Sept. 16. ``Stabilization of our financial system is an essential precondition for economic recovery.''

Bernanke's remarks may stoke investors' expectations for the Fed to lower interest rates by year-end to alleviate the impact of the worst financial crisis since the Great Depression. The Fed chief reiterated his call for Congress to pass Treasury Secretary Henry Paulson's plan for a $700 billion rescue fund to remove devalued assets from the banking system.

Recent financial stress ``will make lenders still more cautious about extending credit to households and businesses,'' Bernanke said. ``The downside risks to growth thus remain a significant concern.''

The rate-setting Federal Open Market Committee left its benchmark rate unchanged at 2 percent this month for a third straight meeting after seven cuts since September 2007. Policy makers next gather Oct. 28-29, when traders see a 74 percent chance of a reduction, futures prices show.

`Market Relief'

Bernanke is ``very much leaning to seeing downside risks to growth as much greater,'' said James O'Sullivan, senior economist at UBS Securities LLC in Stamford, Connecticut. ``If we don't get credit market relief, the risks tilt overwhelmingly to growth rather than inflation.''

After their Sept. 16 meeting, policy makers said ``growth appears to have slowed recently.''

The Fed chairman's testimony today signaled that restrictive credit has now slowed the economy from its 3.3 percent annualized pace in the second quarter to a pace ``appreciably below its potential rate.''

Tumbling housing prices and waning mortgage credit have pushed up borrowing costs for both banks and consumers, and will probably slow the expansion to a 1.7 percent annual rate in 2008, according to the median forecast of 80 economists in a Bloomberg News survey.

Unemployment rose in August to a five-year high of 6.1 percent and payrolls have fallen for eight straight months.

``The weakness in fundamentals underlying consumer spending suggest that household expenditures will be sluggish, at best, in the near term,'' the Fed chairman said. ``The continuing decline in house prices reduces homeowners' equity and puts continuing pressure on balance sheets of financial institutions.''

Construction, Investment

Bernanke said construction of commercial office buildings and business spending on equipment and software are likely to slow. Slowing growth abroad could reduce the lift the U.S. economy received from exports in the first half, he also said.

``If financial conditions fail to improve for a protracted period, the implications for the broader economy could be quite adverse,'' Bernanke said.

Bernanke also said slowing growth should help moderate inflation pressures. The consumer price index rose 5.4 percent for the year ending in August.

``The inflation outlook remains highly uncertain,'' Bernanke said. ``The upside risks to inflation remain a significant concern.''

The Fed chief's remarks are the second of three testimonies in two days. Bernanke yesterday told the Senate Banking Committee in a joint appearance with Paulson that lawmakers should pass the rescue plan quickly. He appears later today at the House Financial Services Committee.

Rescue Plan

Bernanke today reiterated his support for what would be the biggest federal intrusion into markets since the New Deal. Fed officials have so far failed to stem the credit crisis even after the steepest rate cuts in two decades and interventions in Bear Stearns Cos. and American International Group Inc. this year.

The Treasury this month also took over Fannie Mae and Freddie Mac as the turmoil engulfed the two largest mortgage finance companies.

Lawmakers have balked at approving the Treasury's proposal to buy illiquid assets from financial institutions without changes. Republicans resisted the plan's size and scope and Democrats demanded support for homeowners and limits on executive pay.

Pump Dollars

The Fed has also pumped billions of dollars into banks to try and restore liquidity, while invoking extraordinary powers to loan to securities firms.

Along with the bailout, Bernanke supports a regulatory overhaul for a U.S. financial industry upended by $523 billion in losses from the collapse of mortgage credit. The Fed approved this week bids by Goldman Sachs Group Inc. and Morgan Stanley to become banks, ending an investment banking era sealed last week by the bankruptcy of Lehman Brothers Holdings Inc.

Merrill Lynch & Co. agreed to a merger with Bank of America Corp. earlier this month.

Some 6.41 percent of outstanding mortgages were delinquent at the end of June, and 2.75 percent were in foreclosure, according to the Mortgage Bankers Association.

To contact the reporter on this story: Craig Torres in Washington at ctorres3@bloomberg.net.