Federal Reserve Chairman Ben Bernanke said on Wednesday the central bank is ready to ease monetary policy further if the economy weakens and inflation moves lower, hinting policymakers were actively mulling further stimulus.
While holding to a view that recent economic softness would eventually pass, he appeared less confident in that projection -- and more willing to entertain the possibility of another round of stimulus.
The possibility remains that the recent economic weakness may prove more persistent than expected and that deflationary risks might reemerge, implying a need for additional policy support, Bernanke told the House of Representatives Financial Services Committee.
Bernanke specifically noted Fed forecasts for June, which were already revised down significantly from April, had not incorporated recent data, particularly last Friday's dismal employment report. It showed job growth essentially ground to a halt in May and June, while jobless rate rose to 9.2 percent.
U.S. stocks, which have taken a drubbing over the last week on worries about Europe's debt troubles and on concerns about the U.S. economic outlook, rallied 1.2 percent, while Treasury bond prices and the dollar tumbled.
The Federal Reserve remains prepared to respond should economic developments indicate that an adjustment in the stance of monetary policy would be appropriate, Bernanke said.
Pressed on the budget during the question-and-answer session, Bernanke reiterated his warning that a failure to raise the U.S. debt ceiling would deal a severe blow to the global economic recovery.
Minutes from the Fed's June meeting, released on Tuesday, showed some policymakers believe the Fed should stand ready to provide more support to the economy if the recovery flags, rekindling the threat of a debilitating downward spiral in prices and wages.
Others on the policy-setting Federal Open Market Committee, however, felt inflation risks might force the central bank to withdraw stimulus sooner than is currently anticipated.
DOOR OPEN TO QE3
Still, given the change in tune, some investors were betting the more dovish members of the committee would win the day in pushing for a third round of quantitative easing if the economy continues to deteriorate.
My initial reaction was 'QE3 here we come', said Jack Ablin, chief investment officer at Harris Private Bank in Chicago. We suspected the Fed would come up with some sort of QE3 in light of the disturbance surrounding the sovereign debt markets.
Bernanke did not go into great detail regarding Europe, but the Fed chief's outlook on U.S. growth prospects was understandably cautious.
After recovering from the steepest recession in generations beginning in the summer of 2009, the U.S. economy has lost momentum in recent months. Gross domestic product expanded just 1.9 percent in the first three months of the year, and the second quarter does not look to have been much better.
Bernanke held to the view that recent weakness was due in part to temporary factors like high energy costs and the effects on global industry from Japan's earthquake and tsunami.
But he acknowledged the labor market remains weaker than the Fed would like.
The most recent data attest to the continuing weakness of the labor market, Bernanke said.
Bernanke defended the second round of bond buys against critics who said it had been ineffective.
He said the Fed estimates round two of quantitative easing, or QE2, lowered long-term interest rates by between 0.1 and 0.3 percentage point, which Bernanke said would be roughly equivalent to a 0.40 to 1.20 percentage point decline in the federal funds rate, which is currently set in a range between zero and 0.25 percent.
Regarding inflation, Bernanke reiterated the recent rise in prices was mostly linked to transitory factors such as higher energy and commodity prices, and should trend back down.
(Editing by Andrea Ricci and Neil Stempleman)