Bernanke: Stimulus is good, but financial markets need help

WASHINGTON -- Federal Reserve Chairman Ben Bernanke on Tuesday said President-elect Barack Obama's massive stimulus bill could provide a significant short-term economic boost, but warned the government also might need to provide banks more capital or buy troubled assets to ensure lasting recovery.

In a wide-ranging speech to the London School of Economics, Bernanke said it may be necessary to provide more capital injections and loan guarantees to banks and financial firms to stabilize credit markets. "The timing and strength of the (global) recovery are highly uncertain." While he expects continued job losses in the near term, Bernanke is hopeful that later in 2009 the economy should see "at least stability and a stop to the bleeding. It takes awhile for labor markets to recover, however."

Bernanke, who didn't weigh in on the details of the evolving U.S. economic stimulus package, made clear that it is should be only part of a broader government response to combat the worst financial crisis to hit the U.S. and the global economy since the 1930s.

"The incoming administration and the Congress are currently discussing a substantial fiscal package that, if enacted, could provide a significant boost to economic activity," Bernanke said.

"In my view, however, fiscal actions are unlikely to promote a lasting recovery unless they are accompanied by strong measures to further stabilize and strengthen the financial system," he warned. "History demonstrates conclusively that a modern economy cannot grow if its financial system is not operating effectively."

He laid out possible ways the Obama administration could buy troubled assets from lenders, and help the struggling housing market, using the remaining $350 billion of the historic $700 billion financial bailout approved by Congress last year.

While the original purpose of the financial rescue program was to buy troubled assets, the Treasury Department instead used the money to inject capital into banks, hoping that would encourage them to lend. Now, Bernanke appears to be suggesting that policymakers return to the original intent of the plan. The Fed has announced some moves to buy assets, like mortgages, to inject cash into credit markets, but the Fed has not been buying the most risky products.

The Fed chairman also emphasized that the U.S. central bank still has financial tools available to boost the economy, even though it has cut a key interest rate, its main policy weapon, to near zero.

And he promised to quickly unwind massive Fed lending programs when the economy improves, so they don't stoke inflation.

The Treasury Department said later Tuesday that the federal government has run up a record deficit of $485.2 billion in just the first three months of the current budget year.

The deficit is on track to surpass $1 trillion for fiscal 2009 and some economists believe it could go much higher.

The Treasury says the deficit for December totaled $83.6 billion, a sharp deterioration from a year ago, when the government managed a surplus of $48.3 billion.

All the red ink is occurring because of spending on the financial rescue program and the recession, which has depressed tax revenue.

In a question and answer session, Bernanke said he expects continued weakness in the job market in the near term. But he said he is hopeful that later in 2009, "we should begin to see some stability in the economy, if not rapid growth, at least stability and a stop to the bleeding. It takes a while for labor markets to recover, however."

The speech marked Bernanke's first public comments since the Fed last month cut a key short-term interest rate to a historically low range of zero to a quarter of a percentage point to try to spur economic growth and prevent deflation, a widespread, sustained fall in prices that can damage the economy.

The interest rate move capped more than a year of what Bernanke termed an "exceptionally rapid and proactive" central bank response to the global financial crisis, including creation of an alphabet soup's worth of special lending facilities to help banks and other lenders. Aggressive lending by the Fed has pushed outstanding obligations on its own balance sheet from $800 billion to more than $2 trillion.

Bernanke said concerted action by the Fed, other central banks and governments "likely prevented a global financial meltdown in the fall." But he emphasized that the financial system is still struggling, with lenders afraid to extend credit in part because of the large number of troubled assets on their balance sheets, which are difficult to price.

"With the worsening of the economy's growth prospects, continued credit losses and asset markdowns may maintain for a time the pressure on the capital and balance sheet capacities of financial institutions," Bernanke said

He suggested the Treasury Department could buy troubled assets outright or provide guarantees to lenders under which the government would agree to absorb part of any losses by banks. In return for guarantees, the government would demand payment from the lenders.

He also said the administration could consider setting up and capitalizing so-called "bad banks," which would buy assets from financial institutions; the government would get cash and equity in the bad bank in return.

At the same time, Bernanke said governments must tighten regulation of financial firms and markets to ensure the financial crash is not repeated. He pointed out as a particular problem the growth of institutions that are deemed to big to fail, because of the risk that would pose to markets.

"It is unacceptable that large firms that the government is now compelled to support to preserve financial stability were among the greatest risk-takers during the boom period," Bernanke said.

But Bernanke said while he understands the public's anger that banks that caused many of the current financial problems are being rescued by government, he emphasized that economic recovery cannot occur without a functioning financial system.

Regarding Fed policy, Bernanke said one of the central bank's biggest challenges is figuring out how to communicate policy to markets and the public.

He said the Fed can support the economy by expanding lending to financial firms and backstopping markets for products like mortgages, student loans and credit cards.

Bernanke said the central bank will quickly unwind those programs when the economy recovers. Critics of recent Fed policy worry the central bank is taking on too much risk, picking and choosing economic winners and, by essentially printing money, stoking inflation down the line.

"With global economic activity weak and commodity prices at low levels, we see little risk of inflation in the near term; indeed, we expect inflation to continue to moderate," Bernanke said. However, he said, at some point, when credit markets and the economy have begun to recover, the Federal Reserve will have to unwind its various lending programs.

Bernanke noted that most of the Fed's lending programs are short-term, though it has recently created longer term programs. In deciding whether to expand its programs, he said the Fed will "carefully weigh the implications for the exit strategy."