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Fed chief Bernanke expects slower growth, higher inflation

US Federal Reserve Chairman Ben Bernanke on Thursday said he expected slower growth and higher inflation through the end of the year and into early 2008 amid “turmoil” in financial markets and rising energy prices.

Bernanke told Congress in a hearing that despite solid growth of 3.9% in the Q3, the Fed “did not see recent growth performance as likely to be sustained in the near term” as it becomes more difficult for borrowers to obtain credit. But while the subprime mortgage market - which sparked the downturn in financial fortunes over the summer - remained “significantly impaired,” Bernanke said the Federal Reserve had yet to see signs of “spillover” from the crisis in financial markets into broader economic indicators. Still, “financial market volatility and strains have persisted,” he said. “Incoming information on the performance of mortgage-related assets has intensified investors’ concerns about credit market developments and the implications of the downturn in the housing market for economic growth.” Consumer demand remained strong, unemployment remained low and capital spending by businesses was increasing, Bernanke said. But he warned that any future spillover could impact the Fed’s more positive projections for growth by mid-2008. “We think that by the spring, early next year, that as these credit problems resolve and as, we hope, the housing market begins to find a bottom, that the broader resiliency of the economy, which we are seeing in other areas outside of housing, will take control and will help the economy recover to a more reasonable growth pace,” he said.

Bernanke warned that a weak dollar and high commodity prices including oil - which has been threatening to hit 100 dollars a barrel in New York trading - could increase overall inflation. But he defended the dollar’s role as the world’s dominant currency despite its fall to record lows and hints by Chinese officials the country might diversify into other currencies. “I don’t see any significant change in the broad holdings of dollars around the country - around the world. Dollars remain the dominant reserve asset and I expect that to continue to be the case,” he said. He stressed that the strength of the dollar in the medium term does not depend on the portfolios of foreign governments, but “on the strength of the US economy, our trade situation and on the openness of our financial markets to foreign capital.” Chinese officials signaled this week they had plans to diversify the nation’s $1.43 trillion of foreign exchange reserves. China is the largest holder of US dollar reserves. The dollar is “losing its status as the world currency,” Xu Jian, a central bank vice director, was quoted as saying in Beijing by Bloomberg.

Members of Congress echoed his concerns. “I am worried that there may be a bigger storm on the horizon,” Senator Charles Schumer, the Democrat who chairs the Joint Economic Committee said, citing concerns about falling housing prices, lack of confidence in creditworthiness, the weak dollar, and high oil prices, which he called “the four horsemen of the economic crisis.” Given the competing risks of lower growth and higher inflation Bernanke said the Fed was justified in cutting its benchmark rate by a quarter point to 4.5% during its last meeting in October. Bernanke also warned that the defaults in subprime home mortgage loans to borrowers with poor credit, which sparked the “financial turmoil” over the summer, were likely to get worse before the situation gets better as nearly 450,000 borrowers will see their interest rates reset to higher rates by the end of next year. He urged financial institutions to work with the borrowers who are likely to have difficulty meeting the higher payments and cited Fed efforts to help community groups that work to keep homeowners out of foreclosure. The Fed will propose rules by the end of the year to address unfair and deceptive loan practices, he said. “A sharp increase in foreclosed properties for sale could also weaken the already struggling housing market and thus, potentially, the broader economy,” Bernanke said. (m&c.com)