Federal Reserve Chairman Ben Bernanke said Friday the financial crisis that has pounded the country — coupled with higher inflation — is taking a toll on the economy and poses a major challenge to Fed policymakers as they try to restore stability.
"Although we have seen improved functioning in some markets, the financial storm that reached gale force" around this time last year "has not yet subsided, and its effects on the broader economy are becoming apparent in the form of softening economic activity and rising unemployment," Bernanke said in a speech to a high-profile economics conference here.
While Bernanke welcomed the recent drops in oil and other commodities' prices, and believes inflation will moderate this year and next, the Fed chief also warned the inflation outlook remains highly uncertain.
The Fed, he said, would monitor the situation closely and will "act as necessary" to make sure that inflation doesn't get out of hand.
The current financial and economic environment is one of the most challenging to Fed policymakers "in memory," he acknowledged.
Given those dueling economic cross-currents_ weak economic growth and higher inflation — many economists believe the Fed will leave rates where they are at its next meeting on Sept. 16, and probably through the rest of this year.
"They won't act until the coast is clear on financial stability and the state of the economy," said Allen Sinai, chief global economist at Decision Economics Inc. Many fear the economy will hit a rough patch later this year as the bracing effect of the government's tax-rebate checks fades.
Wall Street was buoyed by Bernanke's remarks, a dip in oil prices and growing speculation that Lehman Brothers Holdings Inc. could be sold. In afternoon trading, the Dow rose 135.49 to 11,565.70, the Standard & Poor's 500 index added 7.45 to 1,285.17, and the Nasdaq composite index rose 19.41 to 2,399.79.
Economy is voters' top concern
The economy is the top concern for voters and of keen interest to presidential contenders Sens. Barack Obama and John McCain, who are gearing up for their party's conventions. Financial and credit problems are expected to smolder into next year. And, the unemployment rate, which jumped to a four-year high of 5.7 percent in July, is expected to keep rising.
The bulk of Bernanke's speech dealt with the need to bolster oversight of the nation's financial system to make it better able in the future to withstand future shocks.
To that end, Bernanke recommended that regulators work on ways to assess the health of the entire financial system, rather than the condition of individual banks, Wall Street investment firms or other financial companies — as is currently the focus.
"Such an approach would appear well justified as our financial system has become less bank centered," he said. "Some caution is in order, however, as this more comprehensive approach would be technically demanding and possibly very costly both for the regulators and the firms they supervise." He added that "stress tests" for a range of financial firms might also be helpful.
Bernanke's remarks come amid renewed worries on Wall Street about the financial health of Fannie Mae and Freddie Mac. The mortgage giants' stocks have gotten hammered this week as investors became increasingly convinced a government bailout is inevitable.
How will Fed help the financial sector?
Although the Fed chief didn't mention the companies, he said one of the critical questions facing the country is how to strengthen the financial system and at the same time protect against "moral hazard," where financial companies might feel more inclined to gamble with risks because they believe the Fed or the government will ultimately bail them out.
"Some particularly thorny issues are raised by the existence of financial institutions that may be perceived as 'too big to fail,' and the moral hazard issues that may arise when governments intervene in a financial crisis," Bernanke said.
Mitigating that problem is another challenge facing policymakers, he said.
Bernanke repeated his call for Congress to provide new regulatory powers to insulate the economy from damage if a Wall Street firm collapses. He again urged Congress to give the central bank explicit authority to oversee systems that process payments and other financial transactions by investment firms and banks.
This year's Fed conference examines past and present financial crises, and the challenges confronting Bernanke and other central bankers as they try to help stabilize financial markets worldwide.
The Fed's handling of the credit, financial and housing debacles is likely to spur debate at the forum, which is sponsored by the Federal Reserve Bank of Kansas City and draws Fed policymakers, economists, academics and international central bank officials.
The Fed has taken unprecedented steps over the past year to battle the nation's worst credit and financial crises in decades.
Fed has already slashed interest rates
To brace the wobbly economy, the Fed has slashed its key interest rate by 3.25 percentage points, the most aggressive rate-cutting campaign in decades.
The Fed also has taken some unconventional — and controversial — actions to shore up the shaky financial system and to get credit — the economy's lifeblood — flowing more freely.
In the broadest expansion of its lending powers since the 1930s, the Fed agreed in March to let investment houses draw emergency loans directly from the central bank. As part of JPMorgan Chase & Co.'s takeover of Bear Stearns Cos., the Fed provided a $28.82 billion loan.
In July, the Fed said Fannie and Freddie also could tap the program. For years, such lending privileges were extended only to commercial banks, which are subject to stricter regulatory supervision.
Critics question whether taxpayers are being put at risk and if expanded safety nets will encourage financial companies to act more recklessly in the future.
But Bernanke on Friday again defended the Fed's decisions saying they were needed to avert a financial catastrophe that could have plunged the economy into a deep recession.