The Federal Reserve is sailing further into uncharted territory as it begins to unwind its trillion dollar-plus intervention in the financial markets and U.S. economy. As Fed Chairman Ben Bernanke and central bank policymakers are finding, this new territory is not unlike a place that early mapmakers would have illustrated with demons and dragons.
In his semiannual economic update to Congress Wednesday, Bernanke fielded questions covering a wide range of the perils the Fed faces as it tries to reverse its unprecedented easy credit policy.
“I’m not in any way minimizing how hard this is,” Bernanke told the panel.
In his remarks, Bernanke walked a fine line between highlighting the Fed's accomplishments and acknowledging the challenges that now confront the central bank.
On the one hand, the Fed is trying to prepare investors and businesses for the prospect of higher interest rates after an unprecedented policy of keeping short-term rates near zero. But with the U.S. economy still in the early stages of a wobbly recovery, the Fed has to tread lightly for fear of spooking investors who worry that higher rates could snuff out the rebound.
Bernanke's vow to keep rates low for some time helped boost stock prices Wednesday after a two-day slide.
Even as it seeks that balance, the Fed is trying to navigate a sea filled with perils over which it has little control. On top of the list is a massive federal deficit worsened by congressional efforts to bail out the banking system and stimulate the battered economy. The Obama administration this month proposed a federal budget that would mean a third straight year of $1 trillion-plus deficits.
Treasury Secretary Timothy Geithner addressed that issue in testimony Wednesday to the House Budget Committee when he said stimulus spending today would help control deficits tomorrow.
"If you care about future deficits — and you have to care about these future deficits — you need to care about economic growth today," Geithner said.
Congress is already at work on another round of spending, this time with the goal of taming a stubbornly high unemployment rate. On Wednesday, the Senate approved another $15 billion package of tax breaks and highway spending to create new jobs. The House has already approved a far bigger jobs package that would cost $155 billion.
Bernanke told the panel that "unemployment is the biggest problem we have" and that the government's stimulus spending so far has helped contain it.
"I think most economists would agree that the stimulus has created jobs relative to where the baseline would have been in the absence of the stimulus," he said.
So far, demand for fresh Treasury debt is holding up. But the worry is that too much borrowing here and around the world could spook investors, who would demand a higher return to lend money to the Treasury.
“It is possible that the bond market will become worried about sustainability (of the deficit) and we may find out self facing higher interest rates,” Bernanke told the House panel.
The Fed has even less control over other market forces that could push rates higher. The list includes the ongoing financial turmoil in Greece, where the government’s efforts to control spending and rein in debt has met strong local resistance. On Wednesday, a rally in Athens protesting spending cuts turned violent as police clashed with a crowd of some 50,000 demonstrators.
Bernanke told the House committee that the Fed has no plans to intervene in the debt crisis.
Greece and the European Union are playing what amounts to a game of chicken: Germany and France, which make up the economic flywheel of the single-currency euro zone, are loath to bail out what they see as the free-spending Greek government. European central bankers also fear that a bailout would only reward bad fiscal policies.
But if Greece defaults on its loans, it could push heavily indebted countries like Spain, Portugal and Ireland closer to the edge and imperil other European economies. It remains to be seen which side blinks first.
Meanwhile, the Fed faces looming perils closer to home, including the threat of increasing defaults on commercial real estate loans.
“It remains the biggest credit issue that we still have,” said Bernanke.
Unlike a typical home mortgage, commercial property is backed by much shorter-term lending. That means investors and property owners who paid top dollar at the height of the real estate boom in the middle of the decade are now scrambling to refinance those loans as they come due over the next few years.
Commercial real estate values have fallen by as much as a third, leaving many properties under water. Widespread defaults on these loans could put severe pressure on the smaller banks that hold them, further tightening credit and pushing rates higher for home buyers and small businesses.
The Federal Deposit Insurance Corp. Tuesday reported that the number U.S. banks edging toward trouble rose 27 percent to more than 700 in the latest quarter and that troubled loans continued to increase.
The residential real estate market, one of the main engines of the U.S. economy, also faces a number of critical hurdles. One is the pressure from rising inventory of unsold homes, as the ongoing wave of foreclosures brings more houses to market at distressed prices. The government reported Wednesday that new home sales fell to record low levels in January, in part because of the overhang of that “shadow” inventory.
Since the financial crisis began in September 2008, the Fed has been propping up the housing market by pushing mortgage rates lower through a massive buying spree of mortgage-backed bonds. With the bulk of that $1.25 trillion war chest now spent, the Fed has announced it will stop buying mortgage bonds. The hope is that the housing finance market has recovered enough to sustain mortgage rates at current level. A rise in those rates could cut off access to mortgages for many buyers, throwing more cold water on the housing market.
Bernanke was also quizzed about the ongoing drop in lending, especially among smaller community banks that provide the bulk of credit for small businesses that have traditionally been the biggest source of new jobs. The Fed chairman blamed the drop on “both tightened lending standards and weak demand for credit amid uncertain economic prospects.”
The credit contraction presents the Fed with yet another tough call. As long as credit remains tight, the economic recovery will remain weak. But with the financial system still recovering from a lending spree that produced historic losses, bankers are leery of making more risky bets.