Bernanke warns spending cuts could derail recovery

WASHINGTON: Federal Reserve Chairman Ben Bernanke warned on Thursday, July 14 that overzealous cuts to government spending in the short term could derail a shaky recovery and said a debt default could wreak financial havoc.

"I only ask ... as Congress looks at the timing and composition of its changes to the budget, that it does take into account that in the very near term the recovery is still rather fragile, and that sharp and excessive cuts in the very short term would be potentially damaging to that recovery," Bernanke told the Senate Banking Committee.

Congress and the White House are stalemated in talks on cutting the budget deficit, with Republicans seeking $2.4 trillion in spending cuts in exchange for agreeing to raise the $14.3 trillion government borrowing limit. The Treasury has said it will run out of money after August 2 to pay all of the country's bills if a deal is not reached to raise the debt ceiling.

On the second day of delivering the Fed's semiannual monetary policy report to Congress, Bernanke renewed his warning that a United States debt default would be devastating for the U.S. and global economies.

"It would be a calamitous outcome," Bernanke said. "It would create a very severe financial shock that would have effects not only on the U.S. economy, but the global economy."

Failure to raise the debt limit in time would constitute a "self-inflicted wound" to the economy, he added.

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Moody's Investors Service warned late on Wednesday that the United States could lose its top credit rating in coming weeks if a standoff between the White House and congressional Republicans over raising the statutory borrowing limit is not resolved.

Earlier on Thursday, China -- the United States' biggest foreign creditor -- urged the U.S. government to adopt responsible policies to protect investors' interests after the Moody's warning.

Another ratings agency, Standard & Poor's, also privately told U.S. lawmakers and business groups, a congressional aide said on Thursday, that it might still cut the United States' rating if the government fails to make any of its expected payments -- on debt or other obligations.

In comments that mirrored his remarks on Wednesday, Bernanke said the Fed is prepared to act if the modest recovery from the recession that ended two years ago falters.

He made clear, however, the Fed is not at that point now. For one thing, inflation is higher than in late 2010, when the U.S. central bank readied its most recent round of bond buying, he told lawmakers in response to questions.

"Today the situation is more complex," Bernanke said. "We're not prepared at this point to take further action.

On Wall Street, stocks fell as Bernanke's comments raised questions about the Fed's readiness to ease rates further. The dollar rose against most major currencies as another round of monetary stimulus looked remote.

Economic reports released on Thursday suggested the economy will struggle to regain speed in the second half of the year, as the Fed has forecast. The number of Americans claiming initial unemployment benefits dropped last week, but remained elevated, and retail sales barely rose in June, government data showed.

Also, producer prices in June posted their steepest decline since February 2010 as energy prices eased.

While Fed policymakers have been worried about rising inflation, the risk of a damaging deflationary spiral could force the central bank to act to promote growth.

Economists polled by Reuters cut their outlook for U.S. growth to 2.5 percent this year. That forecast put the United States ahead of major European economies except Germany, but behind some major emerging markets including China.

Although Bernanke told Congress the Fed's recently completed $600 billion bond-buying program has been effective in lowering long-term interest rates and coaxing investors to take greater risks, it has been controversial, and several lawmakers questioned it on Thursday.

"I believe the stage is set for a resurgence of inflation if the Fed is not careful," Senator Richard Shelby told Bernanke at the hearing.

Former Fed chairman Paul Volcker on Thursday also raised doubts about the Fed's ability to ease policy further, adding that more efforts might have negative unintended consequences.

"There are limits as to how much more they can do within things that are feasible for a central bank," he said in an interview with Reuters Insider TV on the sidelines of a conference in London.

"With interest rates so low, practically to the vanishing point, there is always a question of whether you end up inadvertently stimulating speculative activity that you'd just as soon not stimulate," he said.

Volcker's reputation as a former Fed chairman is high because he was willing to plunge the U.S. economy into a painful recession to break the back of high inflation. - Reuters