WASHINGTON — Federal Reserve Chairman Ben Bernanke sketched a bleak picture of the U.S. economy Tuesday – and warned it will darken further if Congress doesn't reach agreement soon to avert a budget crisis.
Without an agreement, tax increases and deep spending cuts would take effect at year's end. Bernanke noted what the Congressional Budget Office has warned: A recession would occur, and 1.25 million fewer jobs would be created in 2013.
The Fed is prepared to take further action to try to help the economy if unemployment stays high, he said. Bernanke didn't signal what steps the Fed might take or whether any action was imminent. And he noted there's only so much the Fed can do.
But the Fed chairman made clear his most urgent concern is what would happen to the economy if Congress can't resolve its budget impasse before the year ends.
Cuts in taxes on income, dividends and capital gains would expire. So would this year's Social Security tax cut and businesses tax reductions. Defense and domestic programs would be slashed. And emergency benefits for the long-term unemployed would run out.
All that "would greatly delay the recovery that we're hoping to facilitate," Bernanke said near the end of two hours of testimony to the Senate Banking Committee.
Bernanke was giving his twice-a-year report to Congress on the state of the economy. He will testify Wednesday before the House Financial Services Committee.
The economy is growing modestly but has weakened, Bernanke said. Manufacturing has slowed. Consumers are spending less. And job growth has slumped to an average of 75,000 a month in the April-June quarter from 226,000 a month from January through March. The unemployment rate is stuck at 8.2 percent.
Bernanke noted that the economy, after growing at a 2.5 percent annual rate in the second half of 2011, slowed to roughly 2 percent from January through March. And it likely weakened further in the April-June period.
Congress needs to resolve its impasse well before the year ends, Bernanke said.
"Doing so would help reduce uncertainty and boost household and business confidence," he said.
The cuts that would kick in next year could cost as many as 2 million jobs, a trade group that represents manufacturers said in a report released Tuesday. The report came from the Aerospace Industries Association.
A separate report Tuesday pointed to the budget crises many states are suffering, caused in part by shrinking revenue from the federal government. States are finding it harder to pay for basic services such as law enforcement, local schools and transportation, the report said. It was issued by the State Budget Crisis Task Force, a non-profit co-chaired by former Federal Reserve Chairman Paul Volcker and former New York Lieutenant Governor Richard Ravitch.
Republicans in Congress are demanding deeper spending cuts while extending income tax cuts for everyone. Democrats want to extend the tax cuts for middle- and lower-class Americans. But they want them to expire for people in the highest-income brackets.
Bernanke stopped short of telling Congress what steps to take. He challenged them to think broadly.
"Congress is in charge here, not the Federal Reserve," he said.
The economy's challenges go beyond the budget impasse, Bernanke said. Lawmakers must also produce a long-term plan to shrink federal budget deficits. Otherwise, he said the United States could eventually suffer a financial crisis marked by rising interest rates. Consumers and businesses would have to pay more for mortgages and many other kinds of loans.
"It would be very costly to our economy," Bernanke said.
Stocks rose sharply despite Bernanke's grim assessment. The Dow Jones industrial average climbed more than 90 points, and broader indexes also gained.
The Fed chairman also said Europe's debt crisis poses a serious threat to the U.S. economy. He said the Fed has been working with U.S. banks to ensure they've taken steps to prepare for a crisis.
"Although I have every hope and expectation that the European leaders will find solutions, there is a risk of a more serious financial blowup," Bernanke said.
Investors had hoped Bernanke would signal another round of bond purchases, to drive down long-term interest rates and encourage more borrowing and spending. But they seemed to shrug off the downbeat outlook and focused on stronger earnings reported by Mattel, Coca-Cola and other big companies.
At least one senator implored Bernanke to take action now.
"Given the political realities of this year's election, I believe the Fed is the only game in town," Sen. Charles Schumer, D-N.Y., said. "I would urge you, now more than ever, to take whatever actions are warranted."
"So get to work, Mr. Chairman," Schumer added.
Even if the Fed announces another round of bond purchases, some economists question how much it might help. They note that mortgage rates and other key borrowing rates are already at record lows.
The economy was already sputtering when the Fed's policymaking committee last met June 19-20. At that meeting, the Fed decided to extend a program that shifts its bond portfolio to try to lower long-term interest rates. The Fed also reiterated its plan to keep its key short-term interest rate near zero until at least late 2014.
Minutes of the June meeting show that Fed officials were open to taking further action – but were divided over whether the economy needs help now.
Former Fed official Roberto Perli, managing director at the research firm International Strategy & Investment, doubts the Fed will take action at its next meeting July 31-Aug. 1, preferring to wait for more evidence of where the economy is headed.
But if growth and job creation continue to weaken, he says, Fed policymakers might unveil another round of bond purchases at its Sept. 12-13 meeting.