Fed warns of risk from ending stimulus

Federal Reserve Chairman Ben Bernanke on Wednesday said the economy must show signs of sustained improvement before the central bank will curtail its long-running monetary stimulus program.

Bernanke offered no timeline as to when the Fed would begin reducing purchases of mortgage-backed assets, saying any decisions would be based on incoming economic data, with a keen eye on improvements in the labor market.

"We are looking at whether or not we have seen real and sustainable progress in the labor market outlook,” Bernanke told the Joint Economic Committee on Wednesday.

"I hope to provide more information going forward, and that we can exit over time in a way that is consistent with our policy objectives," he said.

The Fed is currently engaged in its third round of “quantitative easing” and intends to buy $85 billion in government and mortgage bonds until there is substantial improvement in the labor market.

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Since December, the central bank has said it would hold short-term interest rates near zero until the unemployment rate drops below 6.5 percent — it now stands at 7.5 percent — or inflation climbs above 2 percent. Rates have been near zero since late 2008.

“If we see continued improvement then in the next few meetings, we could take a step down in the pace of purchases," Bernanke said.

But the job market remains "weak" and the unemployment rate is still historically high, Bernanke noted, and he warned against ending the stimulus too soon.

"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."

The Fed chief said he is wary of prematurely slowing the purchases while the economy is still in a fragile recovery, so the central bank is maintaining its approach to buy "a certain amount of assets each month based on data and the labor market over time."

Still, he said that a decline in purchases could be halted swiftly if economic conditions warrant it.

Panel Chairman Kevin BradyKevin Patrick BradyHouse panel advances key portion of Democrats' .5T bill LIVE COVERAGE: Ways and Means to conclude work on .5T package LIVE COVERAGE: Tax hikes take center stage in Ways and Means markup MORE (R-Texas) asked Bernanke if any changes would be made before Labor Day.

"I don't know," Bernanke said.

Republicans have long been concerned with the Fed's policies, arguing its present actions could result in damaging inflation down the line and could send a shock wave through the markets when they exit their investments.

Sen. Pat Toomey (R-Pa.) argued that uncertainty around an exit plan injects significant risks into the economy's health and the trajectory of financial markets.

"There's no risk-free strategy," Bernanke said.

He tried to reassure lawmakers that the markets are well attuned to economic indicators and would certainly "see the data" before the Fed makes a change in policy.

Bernanke touted the Fed's efforts to lift the economy but warned Congress that the central bank's actions will be insufficient to stave off a drag on the economy caused by rising taxes and spending cuts.

A bevy of fiscal policy issues — including the expiration of the payroll tax cut, tax increases, budget caps on discretionary spending and the cuts to government spending from sequestration — are creating headwinds that will "exert a substantial drag on the economy this year," he said.

"Taking them all together, they have the effect of being a drag on economic growth, perhaps more than necessary.”

With interest rates near zero, the Fed “does not have the capacity to fully offset an economic headwind of this magnitude."

"Monetary policy is not omnipotent," Bernanke said.

For months, Bernanke has been warning that the $80 billion in sequester cuts this year could slow the recovery. He has suggested nixing the short-term approach to deficit cutting in favor of a more deliberate approach.

Despite similar warnings of economic damage from economists, lawmakers have yet to take any action on replacing the sequester.

Bernanke reiterated on Wednesday that lawmakers need to shift their focus away from near-term budget cuts and take "more aggressive action to address the long-term issues that puts the budget on an unsustainable path."

The Fed chairman also expressed concern about the damage that could be done to the economic recovery if the central bank maintains historically low interest rates.

While low rates have helped stimulate auto and home purchases, it is hurting those trying to save money and could turn investors toward more credit risk or leveraging, he said, adding that the best way to promote rate increases is for the economy to recover at a faster pace.

"Unfortunately, withdrawing policy accommodation at this juncture would be highly unlikely to produce such conditions," he said.

— This story was first posted at 11:17 a.m. and has been updated.