(MoneyWatch) Federal Reserve Chairman Ben Bernanke warned Wednesday that beginning to withdraw support for the U.S. economy too soon could hinder the recovery.
"A premature tightening of monetary policy could lead interest rates to rise temporarily but would also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further," Bernanke said in prepared remarks for his testimony today before the Joint Economic Committee of Congress.
Investors, businesses and economic forecasters will dissect every word of Bernanke's testimony for clues about when the Fed may start scaling back -- or expand -- its $85 billion in monthly purchases of U.S. Treasuries and mortgage bonds. That policy, known as quantitative easing, is aimed at shoring up the economy by encouraging consumers and businesses to borrow and spend.
"For now, the chairman is clearly putting more emphasis on continued easing," said Jim O'Sullivan, chief U.S. economist with High Frequency Economics, in a research note. "He appears to want that message to set the tone for markets."
For their part, investors saw mainly happy news: Bernanke's comments set off a strong rally on the stock market, sending the Dow Jones industrial average up nearly 150 points, only to quickly give back some of those gains. After a little more than an hour into the trading session, the Dow was up 71 points at 15,455, while the broader-based S&P 500 was up 6 points to 1,676. Gold, silver and copper all rallied strongly.
So far this year, the economy is growing at a "moderate" pace, Bernanke said. His remarks came as the U.S. economy shows signs of getting traction, even as political gridlock in Washington restrains faster growth. The labor market added 165,000 jobs in April, hardly a blockbuster number, but a sharp enough rebound from the previous month to ease fears that the U.S. faces a third consecutive "spring swoon."
But even a hint that the central bank is considering pulling back will effectively tap the economy's brakes, pushing up lending rates and likely denting stocks, as Fed officials seek a sustainable rate of expansion. The Fed on Wednesday also will release the minutes of its monetary policy meeting last month, which could shed further light on its plans.
Several Fed members have recently said the Fed may soon start weaning the economy off the extraordinary monetary support it has received since the financial crisis. "We could reduce somewhat the pace of our securities purchases, perhaps as early as this summer," San Francisco Federal Reserve Bank President John Williams said last week.
Yet other Fed leaders continue to warn against ratcheting back on bond purchases, leaving observers to read the tea leaves on the bank's immediate intentions. Some economists think the Fed will start such tapering as early at its next policy committee meeting in September.
That may not mean a tightening in policy, which risks sending the economy into a wall, but rather less easing.
Other central banks around the world, including the European Central Bank and Bank of Japan, have taken steps of late to ease credit conditions in order stimulate growth.
After expanding at an annualized rate of 2.5 percent in the first three months of the year, the U.S. economy appears to be slowing in the second quarter. That decline appears mostly to stem from the enormous government spending cuts, or sequester, that took effect in March after Congress and President Obama failed to reach a fiscal deal.
In other words, the underlying economy is likely stronger than it looks. Consumers have continued to spend despite a rise earlier this year in payroll taxes. A four-year bull market has pushed stocks into record terrain, making people feel wealthier and encouraging spending. Home prices and housing construction, a key sector, continue to rebound.
"Low interest rates are helping households," Bernanke said in response to a lawmaker's question.
Most economists expect gross domestic product to rise about 2.5 percent this year, compared with 2.2 percent in 2012 and 1.8 percent the previous year, before accelerating in 2014.
Notably, the U.S. is also making progress narrowing the federal deficit, in principle reducing the chances of a confidence-sapping political battle later this year over raising the nation's borrowing limit. The Congressional Budget Office forecast last week that the budget gap -- the difference between what the government collects in taxes and what it spends -- will fall this year to $642 billion. That is roughly $200 billion less than the it had predicted in February and less than half the record deficit of $1.4 trillion in 2009.
If a major question mark hangs over the economy, it is when -- or if -- job-creation will pick up sufficiently to speed the recovery. Indeed, while the housing sector has rebounded and stocks have surged, the labor market remains sluggish. The number of workers relative to the overall population, a key measure of the economy's health, has barely budged since the recession.
Bernanke said the job market remains weak, noting that long-term unemployment is historically high.
Still, Bernanke might have some reason to feel vindicated. Since the recession officially ended in mid-2009, critics have warned that the Fed's assertive monetary easing risked blowing another
bubble and driving up inflation. So far, however, those fears have
proved unfounded. Inflation remains muted, while global investors
continue to regard U.S. debt as a safe haven.
Meanwhile, the third and latest round of quantitative easing appears to have had a more positive effect than many expected. Before the Fed implemented QE3, as the bond purchases were dubbed, in September, the nation's unemployment rate was 8.1 percent. Now it stands at 7.5 percent. Also over that period, payroll gains have jumped from a three-month average of 94,000 before QE3 to 212,000 this year, even amid stasis in Congress, a deepening depression in Europe, and slowing growth in China.
That could hasten tightening, some experts think. "All things considered, we still think that the Fed will begin to curb its asset purchases before the end of the year, with a complete halt sometime in the first half of 2014," said Paul Ashworth, chief U.S. economist with Capital Economics, in a research note.