The country’s economic health won’t snap back quickly even if badly needed confidence in the U.S. financial system returns and roiled markets finally calm, Federal Reserve Chairman Ben Bernanke cautioned Wednesday.
“Stabilization of the financial markets is a critical first step, but even if they stabilize as we hope they will, broader economic recovery will not happen right away,” Bernanke said in a speech to the Economic Club of New York.
The government’s new powers under the $700 billion financial bailout package signed into law two weeks ago should help reduce risks to the economy, Bernanke said.
Tapping that new authority, the Treasury Department announced Tuesday that it will inject up to $250 billion in U.S. banks in return for partial ownership. It is hoped that banks will use the cash infusion to rebuild their reserves and lend money more freely to businesses and consumers.
The government also plans to buy rotten mortgages and other bad debts held by banks, another new power granted by the bailout package.
The rationale behind capital injections and buying bad debts is to unclog credit. That should help financial markets function more normally again and — in time — help the wobbly economy get back on stronger footing.
“We now have the tools we need to respond with the necessary force to these challenges,” Bernanke told the group. Still, he warned, “I am not suggesting the way forward will be easy.”
In his speech, Bernanke did not give a fresh clue about the Fed’s next move on interest rates.
In a coordinated assault on the global financial crisis last week, the Fed and other major central banks ordered hefty rate reductions. The Fed dropped its key rate to 1.50 percent, from 2 percent, in an emergency move.
Many economists said the Fed might cut rates again at its regularly scheduled meeting later this month, or may be later this year.
Bernanke said it is likely economic activity will “fall short of potential for a time.”
A growing number of analysts predict the economy will actually shrink in the final three months of this year and the first three months of next year, meeting the classic definition of a recession.
“Ultimately, the trajectory of economic activity beyond the next few quarters will depend greatly on the extent to which financial and credit markets return to more normal functioning,” Bernanke said.
Even with a flurry of radical steps recently taken by the Fed, the U.S. government and others around the world, “credit markets will take some time to unfreeze,” Bernanke said.
The economy had been losing traction even before the financial crisis intensified last month. Fallout from the housing market’s collapse continues to be the primary source of weakness for the economy and for financial markets.
All the problems have led to employers cutting jobs and other investments. Nervous consumers have hunkered down. Slowdowns overseas is sapping export growth, which had been a key source keeping the economy afloat.
“These restraining influences on economic activity, however, will be offset somewhat by the favorable effects of lower prices for oil and other commodities on household purchasing power,” Bernanke said.
With the economy slowing, inflation should moderate, he added.
As with financial crises in the past, the root of the current debacle is a loss of confidence by investors and the public in the strength of key financial institutions and the overall financial markets.
“The crisis will end when comprehensive responses by political and financial leaders restore that trust, bringing investors back into the market and allowing the normal business of extending credit to households and firms to resume,” Bernanke said.
Besides cutting rates, the Fed has, among other things, repeatedly tapped its Depression-era emergency lending powers to keep money flowing to squeezed institutions. It also has created new programs to provide cash loans to banks and has agreed to supply an unlimited amount of U.S. dollars to some major central banks to reduce pressures in key credit and funding markets.
The Fed also will begin buying vast amounts of short-term debt on Oct. 27. Specifically, the Fed will buy commercial paper — a crucial short-term funding that many companies rely on to pay their workers and buy supplies.
Bernanke pledged to use all available tools and will refine strategies as the Fed adapts “to new developments and the inevitable setbacks.”