Fed ready to ease monetary policy

“The possibility remains that the recent economic weakness may prove more persistent than expected and that deflationary risks might reemerge, implying a need for additional policy support,” Bernanke said in testimony before the U.S. House of Representatives Financial Services Committee.

Tellingly, Bernanke specifically noted Fed forecasts for June, which were already revised down significantly from April, had not incorporated recent data, particularly last Friday's dismal employment report. That data showed job growth essentially grinding to a halt in the last two months, pushing the jobless rate up to 9.2 percent.

Minutes from the Fed's June meeting, released on Tuesday, showed some policymakers believe the Fed should stand ready to provide more support to the economy if the recovery flags, rekindling the threat of a debilitating downward spiral in prices and wages. Others on the policy-setting Federal Open Market Committee, however, felt inflation risks might force the central bank to withdraw stimulus sooner than is currently anticipated.

Financial markets responded immediately to Bernanke's indication that the Fed could resume easing, with stock prices climbing strongly after his testimony was published.

But analysts pointed out that, while Bernanke was suggesting the Fed might add stimulus he also was saying that the current “soft patch” may prove temporary.

“The bottom line is that he has to say he will respond if needed, but it seems he's saying it more as lip service than anything because ultimately he still expects that this slowdown was temporary,” said Tom Porcelli, chief U.S. economist for RBS Capital Markets in New York.

Bernanke did not mention two key issues that were likely to come up repeatedly during the question and answer session before lawmakers: The fight in Washington over the U.S. debt ceiling and a European debt crisis that appears to be getting worse by the day.

The Fed chief's outlook on the economy was cautious. After recovering from the steepest recession in generations beginning in the summer of 2009, the U.S. economy has lost momentum in recent months. Gross domestic product expanded just 1.9 percent in the first three months of the year, and the second quarter does not look to have been much better.

Bernanke held to the view that recent weakness was due in part to temporary factors like high energy costs and the effects on global industry from Japan's earthquake and tsunami.

But he acknowledged the labor market remains weaker than the Fed would like.

“The most recent data attest to the continuing weakness of the labor market,” Bernanke said.

Lawmakers are likely to grill Bernanke on the effectiveness of the Fed's second round of bond buying, a US$600 billion stimulus program just completed at the end of June. Bernanke argues in his testimony that the program was effective at keeping borrowing costs down and stimulating economic activity.

He said the Fed estimates round two of quantitative easing, or QE2, lowered long-term interest rates by between 0.1 and 0.3 percentage point, which Bernanke said would be roughly equivalent to a 0.40 to 1.20 percentage point decline in the federal funds rate, which is currently set in a range between zero and 0.25 percent.

Regarding inflation, Bernanke reiterated the recent rise in prices was mostly linked to transitory factors such as higher energy and commodity prices, and should trend back down.

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