U.S. Federal Reserve Board Chairman Ben Bernanke said today that the U.S. economy is slowing, and could even contact in the first half of 2008.

Speaking to the Joint Economic Committee before the U.S. Congress, Bernanke noted that while the Fed’s recent actions appear to have helped stabilize the situation somewhat, financial markets remain under considerable stress. He said that short-term bank funding markets remain under pressure, and credit and capital have been constrained. The effects of this are spilling over to other areas of the market that haven’t been disrupted so far, he also observed.

“These developments in financial markets–which themselves reflect, in part, greater concerns about housing and the economic outlook more generally –have weighed on real economic activity,” Bernanke added.

“Overall, the near-term economic outlook has weakened relative to the projections released by the Federal Open Market Committee at the end of January,” he said. “It now appears likely that real gross domestic product will not grow much, if at all, over the first half of 2008 and could even contract slightly.”

Bernanke added that the Fed expects economic activity to strengthen in the second half of the year; and growth is expected to proceed at or a little above its sustainable pace in 2009, bolstered by a stabilization of housing activity, albeit at low levels, and gradually improving financial conditions. “However, in light of the recent turbulence in financial markets, the uncertainty attending this forecast is quite high and the risks remain to the downside,” he allowed.

Inflation has also been a source of concern, he added. Yet, the Fed expects inflation to moderate in coming quarters, he said. “That expectation is based, in part, on futures markets’ indications of a leveling out of prices for oil and other commodities, and it is consistent with our projection that global growth–and thus the demand for commodities–will slow somewhat during this period,” he explained.

With this weak economic outlook and fragile investor confidence, Bernanke tried to make the case that the Fed’s role in the rescue of Bear Stearns did not amount to a bailout. “Normally, the market sorts out which companies survive and which fail, and that is as it should be. However, the issues raised here extended well beyond the fate of one company,” he said.

“With financial conditions fragile, the sudden failure of Bear Stearns likely would have led to a chaotic unwinding of positions in those markets and could have severely shaken confidence… Given the current exceptional pressures on the global economy and financial system, the damage caused by a default by Bear Stearns could have been severe and extremely difficult to contain. Moreover, the adverse effects would not have been confined to the financial system but would have been felt broadly in the real economy through its effects on asset values and credit availability,” Bernanke argued.

“Clearly, the U.S. economy is going through a very difficult period. But among the great strengths of our economy is its ability to adapt and to respond to diverse challenges. Much necessary economic and financial adjustment has already taken place, and monetary and fiscal policies are in train that should support a return to growth in the second half of this year and next year. I remain confident in our economy’s long-term prospects,” he concluded.

Economic research firm Global Insight Inc. says that Bernanke’s Congressional testimony indicates rates are surely heading yet lower in the U.S.

The firm says that Bernanke “was more blunt and upfront about the prospects for the economy” than he has been in earlier testimony, and he said that the risks to the outlook remain on the downside. “His comments on the economic outlook presage another downward revision to the Fed’s central tendency forecast at the upcoming semi-annual testimony in July, and bring the Fed’s outlook more closely into line with Global Insight’s expectation of a slight contraction during the first half of 2008,” it finds.

Bernanke also vigorously defended the Fed’s actions to prevent the bankruptcy of Bear Stearns, it says, arguing that the damage of a Bear Stearns default would have been severe and extremely difficult to contain. Global Insight says it agrees with this view, given the progressive and severe deterioration in financial market conditions that we have seen since early August 2007.

“Overall, his testimony was refreshingly candid and blunt about the risks to the financial system and the outlook for real growth. The Fed was somewhat tardy in terms of its recognition of these systemic risks as they unfolded over the past eight months,” it says, noting that this has forced the Fed to pull out all the stops by the end of first-quarter
2008 to reduce the risks of further tightening in credit conditions and another major financial domino going down.

“Looking forward, we would agree that the dominant risks to the outlook remain on the downside. While Bernanke states that the economy ‘could contract in the first half of 2008,’ Global Insight holds the view that a fairly significant contraction of domestic demand and gross national income is very likely during this time period, while risks to the financial system, including the financial health of critical players such as the bond insurers, remain extremely elevated,” it concludes. “As a result, we expect the FOMC will move to lower interest rates by a further 75 basis points over the next two months, which will take the target federal funds rate down to 1.50% by July.”