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Thursday, July 14, 2011

Bernanke: Fed ready to act if economy worsens

Federal Reserve Chairman Ben Bernanke told lawmakers Wednesday the Fed is ready to act if the economy gets weaker. He warned them that allowing the nation to default on its debt would send "shock waves through the entire financial system."

Underscoring how fragile the economy remains two years after the Great Recession, Bernanke laid out three new steps the Fed could take, including a fresh round of government bond purchases designed to stimulate economic growth.

"We have to keep all the options on the table. We don't know where the economy is going to go," Bernanke told the House Financial Services Committee.

The Fed chairman stopped short of promising anything, but Wall Street appeared comforted that the central bank was poised to act. The Dow Jones industrial average was up more than 150 points during his testimony to Congress, and closed up 45.

But some of the early stock gains were lost after Richard Fisher, president of the Federal Reserve Bank of Dallas, said in a speech that the Fed had already "pressed the limits of monetary policy."

"If we went so far as to default on the debt, it would be a major crisis because the Treasury security is viewed as the safest and most liquid security in the world," he said.

"It's the foundation for most of our financial -- for much of our financial system," he added. "And the notion that it would become suddenly unreliable and illiquid would throw shock waves through the entire global financial system."

The Fed bought $600 billion in government bonds late last year and early this year, a program designed to keep interest rates low and support the prices of assets such as stocks.

It was the second time the Fed had taken that step since the recession started. It was known on Wall Street as "QE2," or a second round of "quantitative easing." Besides a third round, Bernanke laid out two additional options if the economy gets weaker:

-- The Fed could offer financial markets more clarity about how long it tends to leave interest rates at record lows, where they have stood since December 2008. For now, the Fed says only that rates will remain "exceptionally low" for an "extended period."

-- It could start paying banks less interest on the excess money they park with the Fed. It doesn't pay much now -- 0.25 percent. But paying even less would encourage the banks to loan the money out rather than sending it to the central bank.

Bernanke said the measures would be necessary only if deflation, a cycle of falling prices that damages the economy, became a threat. For now, prices are still rising. Some inflation is healthy, economists say.

Critics of the Fed's two previous rounds of "quantitative easing" have said the real threat is the opposite -- that the central bank will create runaway inflation by flooding the economy with money.

Bernanke said the Fed was ready to raise interest rates if inflation becomes a serious threat.

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China worried about US economy

China is watching whether the Federal Reserve launches a new stimulus that might hurt China by pushing up commodity prices, a Cabinet researcher said Thursday.

The U.S. economy "has been doing worse than expected" and Beijing needs to "seriously assess" possible risks to its vast holdings of American debt, said Yu Bin, an economist in the Cabinet's Development Research Center.

"The prospects of the U.S. economy are worrying," Yu said at a government-organized briefing. Beijing uses such briefings to explain official views, though the researchers do not act as government spokespeople.

Yu expressed concern about a possible third round of Fed purchases of government bonds, known as "quantitative easing" or QE. He said that might hurt China by depressing the value of the dollar and driving up prices of commodities needed by its industries. Most commodities are traded in dollars.

The Fed bought $600 billion in bonds late last year and early this year to keep interest rates low and support prices of assets such as stocks. On Wednesday, Chairman Ben Bernanke said the Fed was ready to take action if the U.S. economy weakens and said a third round of purchases was a possible option.

"We are following closely whether the United States will introduce QE3, because we believe it will have a major impact on China's economy," said Yu, director-general of the Development Research Center's Department of Macroeconomic Research.

"The drastic rise in commodity prices caused by the devaluation of the U.S. dollar will have a major impact on inflation, on economic growth and on Chinese people's daily lives."

Yu warned that such a move also would affect the "long-term trajectory of the U.S. economy."

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