Fed Chair Says U.S. Housing Slump Will Be Drag on Economy

A deepening housing slump probably will be a "significant drag" on economic growth into next year and it will take time for Wall Street to fully recover from a painful credit crisis, Federal Reserve Chairman Ben Bernanke warned Monday.

Bernanke once again pledged to "act as needed" to help financial markets — which have suffered through several months of turbulence — function smoothly and to keep the economy and inflation on an even keel.

"Conditions in financial markets have shown some improvement since the worst of the storm in mid-August, but a full recovery of market functioning is likely to take time, and we may well see some setbacks," Bernanke said in a speech to the New York Economic Club. A copy of his remarks were made available in Washington.

It was Bernanke's most extensive assessment of the country's current economic situation since the August turmoil unhinged Wall Street.

The ultimate implications of the credit crunch on the broader economy, however, remain "uncertain," the Fed chief said.

Against that backdrop, Bernanke said the central bank will be closely watching the economy's vital signs in determining the Fed's next move. He didn't specifically commit to cutting rates again, but rather kept his options open.

Economists have mixed opinions on whether the Fed will lower interest rates at their next meeting, Oct. 30-31. Some insist the odds are lessening that the Fed will need to slice rates; Others, however, think rates will move lower.

"The Fed appears to be in watch mode at the present time," said Lynn Reaser, chief economist at Bank of America's Investment Strategies Group.

To help cushion the economy from the ill effects of the credit crunch and housing slump, the Fed on Sept. 18 slashed a key short-term interest rate by one-half percentage point to 4.75 percent. It marked the first rate cut in more than four years. It also reflected the most aggressive action taken by the Fed to curb fallout from the credit crisis, which intensified in August.

Since that September meeting, the housing slump — the worst in 16 years — has gotten deeper, Bernanke said.

"The further contraction in housing is likely to be a significant drag on growth in the current quarter and through early next year," he said.

"However, it remains too early to assess the extent to which household and business spending will be affected by the weakness in housing and the tightening in credit conditions," he added.

Spending by businesses and individuals is an important ingredient to keeping the economic expansion — which began in late 2001 — from fizzling out.

Developments affecting the job market and income growth also will be watched closely. "The labor market has shown some signs of cooling, but these are quite tentative so far, and real income is still growing at a solid pace," Bernanke observed.

The benefits of a mostly sturdy employment climate have helped cushion some of the negative effects that the housing slump, weaker home values and a credit crunch have had on consumers.

Job creation rebounded in September, with employers boosting payrolls by 110,000, the most in four months. Wages grew solidly. The unemployment rate did creep up to 4.7 percent last month but that rate is still considered low by historical standards.

Given all the problems faced by the economy, the economic performance so far this year "has been reasonably good," Bernanke said.

On the inflation front, Bernanke noted that the prices of crude oil and other commodities have been rising and that the value of the dollar has weakened. Oil prices galloped to a record high of $86.13 a barrel on Monday.

Bernanke said the Fed will continue to monitor inflation developments carefully. Yet, with the limited information seen since the central bank's September meeting, the inflation barometers "are consistent with continued moderate increases in consumer prices," he said.

The Fed's September rate reduction, Bernanke said, has helped ease "some of the pressure in financial markets, although considerable strains remain." He said Fed policymakers were prepared to "reverse" the rate reduction if inflation turned out stronger than expected.

The Fed's next move will be determined by what is best for the economy, Bernanke suggested. As he has said previously, it is not the Fed's job to shield investors from the consequences of bad financial decisions.

"The truth is that it (the Fed) can hardly insulate investors from risk, even if it wished to do so," Bernanke said. "Developments over the past few months reinforce this point. Those who made bad investment decisions lost money."

The worst carnage has affected investors in "subprime" mortgages — those made to people with spotty credit or low incomes. Some lenders have been forced out of business and some investors in those and related mortgage-backed securities have taken a huge financial hit.

Overstretched homeowners with subprime loans got clobbered by the mortgage meltdown, too. Foreclosures and late payments have soared.

Weaker home prices seen during the housing bust have made it more difficult for some subprime borrowers to refinance out of loans that offered low "teaser" rates but jumped to much higher rates, resulting in payment shocks. Delinquencies on these mortgages are expected to rise further, Bernanke predicted.