Federal Reserve Chairman Ben Bernanke boldly predicted to Congress on Tuesday that rising oil prices will cause only a brief and modest rise in consumer inflation.
If he's wrong, as some lawmakers suggested to him, the risks are high: a weaker economy and elevated consumer inflation.
Bernanke's credibility is at stake, too. His duties as Fed chief require a balancing act: Leading the economy to stronger growth while making sure inflation doesn't rise too high.
Appearing before the Senate Banking Committee, Bernanke faced sharp questions about whether rising gasoline prices could spread dangerous inflation through the economy. He said he did not think so.
"The most likely outcome is that the recent rise in commodity prices will lead to, at most, a temporary and relatively modest increase in U.S. consumer price inflation," Bernanke said.
Still, persistently higher prices could shake consumer confidence, prompting consumers to reduce spending. And that would weaken the economy, he acknowledged.
Gas prices jumped over the weekend to a new nationwide average of $3.37 a gallon. That's 26.7 cents a gallon more than a month ago. Food prices in January rose at the fastest since the fall of 2008.
Sen. Patrick Toomey, R-Penn., called the rise in commodity prices "stunning." Toomey said he worries about the effects of those higher prices, combined with the Fed's efforts to boost the economy through a Treasury bond-purchase program. Toomey said they might be "planting the seeds of serious inflation down the road."
Bernanke defended the Fed's $600 billion Treasury bond-buying program. He said it is still needed to energize the economy and reduce unemployment, now at 9 percent. The bond-buying program is intended to lower rates on loans and lift stock prices, spurring more spending and invigorating the economy. The purchases are scheduled to end in June.
Republicans in Congress and some Fed officials say they fear the bond purchases could trigger high inflation and a wave of speculative buying on Wall Street that could lead to new bubbles in the prices of assets like stocks and bonds.
"Once price stability has been lost, it is difficult and very costly to regain," warned Sen. Richard Shelby of Alabama, the panel's top-ranking Republican.
Shelby pointed to the toxic situation in the late 1970s and 1980s when inflation hit double digits. To combat out-of-control prices, Fed Chairman Paul Volcker ratcheted up interest rates. Unemployment soared. And the economy fell into a deep recession.
Bernanke said the rise in oil and global commodities prices was due to stronger demand from fast-growing countries like China, not to the Fed's stimulative policies. But he ran into concerns from Democrats as well as Republicans on the committee.
"I see food prices rising," said Sen. Robert Menendez, D-N.J. "I see gas prices rising even before what was happening in North Africa, although that certainly is an exacerbating reality. Tuition rates rising... I just see a combination of rising prices for the average family."
One reason the Fed launched the bond-buying program in November was to prevent deflation — a prolonged drop in prices of goods, wages and values of homes and stocks. But Bernanke told lawmakers that the risk of deflation has become "negligible."
Political upheaval in the Middle East has caused oil and gasoline prices to march higher, Bernanke said. Still, the Fed chief said he and a majority of his colleagues say they believe the situation won't cause out-of-control inflation.
Workers have little power to demand big pay increases because the jobs market is still weak. That will prevent inflation from igniting, Bernanke said.
The Fed regularly reviews its bond-purchase program. It could buy fewer securities if the economy were to grow more strongly than anticipated or if inflation showed signs of breaking out. Or it could buy more if the economy was in danger of weakening. Most economists believe the Fed will spend the full $600 billion on schedule.
On a separate issue, Bernanke said a failure by Congress to boost the government's borrowing authority would be an "extremely dangerous and a recovery-ending event."
Republicans in Congress want to link any increases in the nation's debt limit to cuts in federal spending to reduce the budget deficit. Democrats oppose that strategy.
In the unlikely event that Congress didn't raise the debt ceiling, the federal government wouldn't be able to pay its bills, triggering a crisis, Bernanke said. Interest rates would spike, slowing spending by Americans and derailing the recovery.
Bernanke also said that a House Republican plan to cut spending would reduce economic growth and employment. But he suggested the impact would be limited.
Republicans want to slash $60 billion-plus from agency budgets in coming months as a down payment on larger cuts later in the year. But they are settling for just $4 billion in especially easy cuts as the price for a two-week stopgap bill to avert a government shutdown.
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