Washington (CNN) - Federal Reserve Chairman Ben Bernanke is warning Congress that the economic outlook remains "unusually uncertain," although he says the Fed is planning for the ultimate withdrawal of the substantial funds it has injected into the financial system since the onset of the economic crisis in 2008.
After Bernanke's statement before a Senate committee Wednesday, stocks turned sharply lower, with the Dow Jones industrial average down more than 100 points.
In prepared testimony for the Fed's semiannual report on monetary policy, Bernanke emphasizes more than once that economic conditions are likely to keep its short-term interest rates at "exceptionally low levels ... for an extended period," explaining that inflation is likely to remain low for several years. At the same time, he offered the most extensive look yet at the Fed's plans and options for pulling money out of the system and raising short-term rates, as the economy improves.
Bernanke says that he and other top Federal Reserve officials expect "continued moderate growth, a gradual decline in the unemployment rate, and subdued inflation over the next several years." However, the Fed chairman says that unemployment will drop more slowly than was predicted earlier this year.
Bernanke says that most of his colleagues on the Federal Open Market Committee, which sets interest rates and other aspects of the Fed's monetary policy, expect annual growth of 3 to 3.5 percent in 2010, and a slightly higher rate of 3.5 to 4.5 percent in 2011 and 2012. But while not mentioning the possibility of a double-dip recession, they also see the risks for growth as "weighted to the downside."
The chairman says most market committee members expect the unemployment rate to decline to between 7 and 7.5 percent by the end of 2012.
Bernanke says that although consumer spending appears to have expanded at a real rate of 2.5 percent in the first half of 2010, he stresses that an "important drag on household spending" is the slow recovery of the labor markets. He says "in all likelihood, a significant amount of time will be required to restore the nearly 8.5 million jobs that were lost over 2008 and 2009." And he emphasizes the "exceptional near-term hardships" on workers and their families now taking place, as well as the potential erosion of skills and possible long-lasting effects on employment and earnings prospects.
One other factor underlying the weaker outlook, says Bernanke, is that although financial conditions have improved significantly, they have become "less supportive of economic growth in recent months." He cites the situation in Europe as one contributing factor, but says that temporary swap lines with the European Central Bank and other entities have helped maintain credit availability in the United States.
Bernanke also laid out some of the alternatives to reducing the Fed's balance sheet from its current $2 trillion to a more normal level, but doesn't indicate that this will be a rapid process.
One approach is to continue to gradually reduce the holdings of mortgage-backed securities by not reinvesting prepayment and interest income. This could also be done for treasury-backed securities. Also, the Fed envisions shifting its holdings of treasuries to bonds of shorter maturities.
The chairman also says that selling off some holdings of mortgage-backed securities and other agency securities will be an essential, although eventual, method of shrinking its balance sheet. But he stressed that because such changes could affect financial conditions, any sales would be based on the Federal Open Market Committee evaluation of economic conditions.
Finally, Bernanke made it clear that one tool that the Fed will use to raise interest rates, when the time comes, is raising the interest rate it pays on the reserve balances that banks are required to keep on deposit with the Fed. Bernanke says that the Fed may drain excess reserves at the same time it raises short-term rates.