Fed is prepared to keep U.S. out of recession, Bernanke vows

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Faced with fresh evidence that the economic recovery is faltering, Federal Reserve Chairman Ben S. Bernanke pledged that the central bank stood ready to redouble efforts to prevent the nation from slipping back into recession.

His remarks came after the Commerce Department sharply downgraded the nation’s economic growth in the second quarter, the latest in a string of indicators to suggest that the risk of a “double-dip” recession had increased.

“We have come a long way, but there is still some way to travel,” Bernanke told a gathering of bankers and economists in Jackson Hole, Wyo., on Friday. He promised that the Fed “will do all that it can do to ensure continuation of the economic recovery.”

Stocks rallied, with the Dow Jones industrial average rising more than 160 points to 10,150.65, its biggest gain since Aug. 2. Markets had fallen sharply this week after a series of negative reports on housing and unemployment.

However, Bernanke said the recovery had not slowed enough for the Fed to take action. He predicted that growth would pick up in 2011, stressing that though the recovery was flagging, the economy was still improving.

The anemic annualized growth rate of 1.6% was down from last month’s estimate of 2.4% but was not as bad as the 1.3% rate that many economists had forecast.

“He had to walk a fine line between worrying people about the outlook yet saying if the outlook does worsen, we will take the steps necessary to come to the aid of the economy,” said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi in New York.

“I think the market kind of likes the idea that he stands ready to do things.”

Bernanke outlined three possible options for shoring up the shaky economy: The Fed could expand its purchases of long-term securities, lower the interest rate it pays to commercial banks for their reserves or make more public assurances, such as committing to hold its short-term interest rate at near zero for even longer than the “extended period” it has promised.

“They still have some pretty good ammunition,” said Brian Bethune, chief U.S. economist at IHS Global Insight.

As the effect of the federal government’s $814-billion stimulus begins to wane — and with political battles in Washington and soaring deficits making any major new stimulus effort highly unlikely — the Fed will play an even more important role in trying to keep the economy out of another recession.

“The economy’s struggling to walk on its own two feet,” Bethune said. “The Fed is there holding its hands…. If the economy falls down, the Fed is going to have to pull harder.”

After the economy grew at a 5% annualized rate in the final three months last year and at a 3.7% rate in the first quarter, the recovery lost steam.

In reducing the second-quarter estimate Friday, the Commerce Department’s Bureau of Economic Analysis said its decision was based on more complete data and primarily reflected a sharp rise in imports and a sharp decline in corporate inventory purchasing.

The drop in inventory investment was partially offset by an increase in consumer spending, as well as increases in federal, state and local government spending.

But the widening trade deficit was a major drag on the recovery. Exports of goods and services increased 9.1% in the second quarter, compared with 11.4% in the first quarter. Imports soared 32.4% in the second quarter after rising 11.2% in the first.

The government routinely revises its quarterly reports on domestic economic output, also known as gross domestic product. Friday’s action revised an estimate of second-quarter GDP that was released July 30. Typically, a revision moves the rate about 0.5%.

Economists had projected that the latest revision could put economic growth as low as 1.3%. Still, Friday’s report was discouraging because growth below 2% reflects a very weak recovery.

“We’re still expanding,” Rupkey said. “I think everybody’s just feeling the disappointment that it’s not quite as quick as we thought, which means people won’t be put back to work as quick as we thought.”

He and other economists were encouraged that consumer spending from April through June was revised upward to 2% from an earlier estimate of 1.6%.

Consumer sentiment improved slightly in August, according to survey results released Friday by Thomson Reuters and the University of Michigan. Even so, just 1 in 4 households expected their finances to improve in the year ahead, the survey found.

Bernanke said that although the Fed had options for boosting the recovery, others had roles to play as well. Consumer spending and increased business investment “must ultimately take the lead.”

On the whole, he said, “that critical handoff appears to be underway.”

“He’s clearly stating that he’s not out of ammunition but he’s not the only one in this fight either,” said Gregory D. Hess, an economist and dean of the faculty at Claremont McKenna College.

The Fed had hoped to pull back its extraordinary support for the economy by now. But as growth slowed, it had to shift its strategy. This month, the central bank said it would resume buying U.S. Treasury bonds to hold down longer-term interest rates instead of beginning to shrink its huge, $2-trillion, portfolio.

Bernanke said Friday that the central bank could decide to expand its purchases of long-term securities.

Rupkey said an announcement by the Fed of a large purchase, such as $500 billion worth, would help keep mortgage rates at record lows for months. But he doesn’t think the Fed will make such a move unless the economy loses jobs for two straight months.

Bernanke said the Fed also could lower or even eliminate the 0.25% interest rate it pays to commercial banks for excess reserves they keep at the Fed. That, he said, would encourage them to lend that money to others instead, and help stimulate the economy.

He said there was not a significant risk of the economy “falling into deflation” — a harmful cycle of lower prices that damages growth. But he said the Fed was prepared to “strongly resist [downward] deviations from price stability.”