Bernanke says credit crisis menacing U.S. economy

NEW YORK (Reuters) - Federal Reserve Chairman Ben Bernanke on Wednesday gave a dour assessment of the U.S. economy, citing a "significant threat" from shuttered credit markets in remarks that indicated he was open to cutting interest rates further.

Together with dismal data on retail sales and factory growth, the remarks helped send U.S. stocks on their greatest one-day percentage slide since the 1987 crash.

Bernanke said it will take some time to restore normal credit flows and pledged the U.S. central bank would continue to act aggressively to fight the crisis. Importantly, he said inflation risks were ebbing, which suggests Fed officials see latitude to lower borrowing costs further.

"By restricting flows of credit to households, businesses, and state and local governments, the turmoil in financial markets and the funding pressures on financial firms pose a significant threat to economic growth," Bernanke told the Economic Club of New York.

"We will continue to use all the tools at our disposal to improve market functioning and liquidity," he said, adding that policy-makers' aggressive and quick response crucially distinguished this episode from the crisis of the 1930s.

Still, Fed Vice Chairman Donald Kohn, speaking separately in New York, said escalating mistrust among financial institutions has hampered the immediate benefits of lower interest rates. At the same time, he said, inflation was likely to move lower as the banking crisis dragged on growth.

St. Louis Fed President James Bullard said the unexpectedly sharp 1.2 percent drop in September retail sales reported on Wednesday increased the risk of recession. "The third quarter, I think, will be flat to slightly negative," he told reporters in Little Rock, Arkansas. "That is going to push up the probability that it will later be named a recession."

RATE CUT SEEN

The data contributed to expectations that Fed officials will follow up the emergency interest rate cut made last week with another reduction at their scheduled next meeting on October 28-29.

In concert with central banks around the globe, the Fed cut benchmark rates by a half point to 1.5 percent last week. It said an intensification of the financial crisis had raised risks to growth, while curbing the risk of inflation.

In the latest bid to restore financial market stability, the U.S. government on Tuesday announced a dramatic plan to recapitalize banks, beginning with a $125 billion equity investment in nine major financial institutions.

But even with the government scrambling to restore credit, Bernanke cautioned it will take time for the economy to heal.

"Stabilization of the financial markets is a critical first step, but even if they stabilize as we hope they will, broader economic recovery will not happen right away," he said.

Kohn agreed: "The troubles in credit markets have spilled over into the economy," he said.

Analysts said Bernanke's words suggested the Fed chief saw the deteriorating outlook as calling for another rate cut.

"Bernanke's comments reinforce the sense that the Fed will lower interest rates when it meets again," said Tony Crescenzi, chief bond market strategist at Miller, Tabak & Co in New York.

Kohn, meanwhile, said he was hopeful that the government's plan to inject $250 billion in equity into ailing banks would be effective in thawing credit markets.

"It's not going to cure all the ills, but it's a very important step in that direction," Kohn said. "The situation here is quite severe."

FEW BRIGHT SPOTS

A Fed report prepared for the central bank's next meeting added to the gloomy news about the economy.

The Beige Book said economic activity had weakened across the country in recent weeks as businesses revisited capital investment plans, consumers curtailed spending and labor markets softened. The Fed described business contacts as "pessimistic."

In his speech, Bernanke said the housing sector remained the economy's weakest spot, but he also cited "marked slowdowns" in consumer spending, business investment and the labor market.

He added that credit markets would take time to unfreeze and said export sales, until recently a bright spot, were likely to slow as well.

While inflation had been high recently, Bernanke said expectations of future inflation had held steady or eased, import prices were moderating and commodity prices had fallen.

Those factors, along with the softness in the economy, "should lead to rates of inflation more consistent with price stability," he said. "I think the evidence is now in that the inflation problems are moderating and look to be returning to price stability at a reasonable pace."

Boston Fed President Eric Rosengren was more direct.

"One of the characteristics of a recession is in each of these recessions the inflation rate has come down quite dramatically," he told a real estate group in Boston.

"We're in a period when the economy is likely to grow quite slowly. The events of the last couple of weeks certainly aren't going to help."

(Additional reporting by Scott Malone in Boston; Writing by Mark Felsenthal and Tim Ahmann; Editing by Leslie Adler)