Bernanke: deep spending cuts could derail recovery

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Federal Reserve Chairman Ben Bernanke warned Congress on Thursday that overzealous cuts to government spending could derail an already fragile recovery and said a U.S. debt default could wreak financial havoc.

I only ask ... as Congress looks at the timing and composition of its changes to the budget, that it does take into account that in the very near term the recovery is still rather fragile, and that sharp and excessive cuts in the very short term would be potentially damaging to that recovery, Bernanke told members of the Senate Banking Committee.

Congress and the White House are stalemated in talks on cutting the budget deficit, with Republicans seeking $2.4 trillion in spending cuts in exchange for agreeing to raise the $14.3 U.S. government borrowing limit. The U.S. Treasury has said it will run out of money after August 2 to pay all of the country's bills if the a deal is not reached to raise the debt ceiling.

On the second day of delivering the Fed's semiannual monetary policy report to Congress, Bernanke renewed his warning that a U.S. debt default would be devastating for the U.S. and global economies.

It would be a calamitous outcome, Bernanke said. It would create a very severe financial shock that would have effects not only on the U.S. economy but the global economy.

Failure to raise the debt limit in time would constitute a self-inflicted wound to the economy, he added.

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Moody's Investors Service warned late on Wednesday that the U.S. could lose its top credit rating in coming weeks if a standoff between the White House and congressional Republicans over raising the statutory borrowing limit is not resolved.

Earlier on Thursday China, the United States' biggest foreign creditor, urged the U.S. government to adopt responsible policies to protect investor interests after the Moody's warning.

Another ratings agency, Standard & Poor's, also privately told U.S. lawmakers and business groups that it might still cut the U.S. government's rating if the government fails to make any of its expected payments -- on debt or other obligations -- a congressional aide said on Thursday.

Bernanke's comments closely reflect remarks delivered to a House of Representatives panel on Wednesday.

Bernanke repeated that the Fed is prepared to act if the modest recovery from the recession that ended two years ago falters.

Economic reports released on Thursday offered mixed signals about the path of the world's largest economy, which grew at a tepid 1.9 percent annual rate in the first three months of the year and is not expected to expand much more quickly in the second quarter.

Retail sales rose in June, and claims for unemployment benefits fell last week. However, last month's producer prices posted their steepest decline since February 2010 as energy prices eased.

While Fed policymakers have been worried about rising inflation, the risk of a damaging deflationary spiral could force the central bank to act to promote growth.

A separate report showed business inventories rose in May as sales posted their first drop in almost a year.

Although Bernanke said the Fed's $600 billion bond buying program has been effective in lowering long-term interest rates and coaxing investors to take greater risks, it has been controversial.

I believe the stage is set for a resurgence of inflation if the Fed is not careful, Senator Richard Shelby told Bernanke at the hearing.

(Reporting by Mark Felsenthal; Editing by Neil Stempleman)

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