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Bebeto Matthews, Associated Press
Ben S. Bernanke

Federal Reserve Chairman Ben S. Bernanke said the U.S. is facing "grave threats" to financial stability and warned that the credit crisis has started to damage household and business spending.

"Economic activity appears to have decelerated broadly," Bernanke said Wednesday to a congressional Joint Economic Committee hearing, downgrading the assessment of Fed officials when they met on Sept. 16. "Stabilization of our financial system is an essential precondition for economic recovery."

Bernanke's comments, his most dire about the economy since he became central bank chief in 2006, may stoke investors' expectations the Fed will lower interest rates by year-end to alleviate the credit crisis. He reiterated his call for Congress to pass Treasury Secretary Henry Paulson's plan for a $700 billion fund to remove devalued assets from the banking system.

Without the bailout, "credit will be restricted further for homeownership, for small business, for individual consumers and so on, but that is not just an inconvenience," Bernanke said. "What that is going to do is affect spending and economic activity, and it will cause the economy as a whole to decline and be much weaker than it otherwise would be."

The Federal Open Market Committee left its benchmark rate unchanged at 2 percent this month for a third straight meeting after seven cuts since September 2007. Policymakers next gather Oct. 28 and 29, when traders see a 78 percent chance of a reduction, futures prices show.

"The downside risks" to economic growth "remain a significant concern," Bernanke said.

Lawmakers including Rep. Paul Kanjorski, the second highest-ranking Democrat on the House Financial Services Committee, said taxpayers don't want to rescue mortgage lenders and other financial institutions viewed as responsible for the credit crisis.

Taxpayer interests "must trump those of corporate fat cats and cowboy capitalists," Kanjorski of Pennsylvania told Bernanke.

The Fed chairman's testimony Wednesday signaled that restrictive credit has now slowed the economy from its 3.3 percent annualized pace in the second quarter to a pace "appreciably below its potential rate.'

Bernanke is "very much leaning to seeing downside risks to growth as much greater," said James O'Sullivan, senior economist at UBS Securities LLC in Stamford, Connecticut. "If we don't get credit market relief, the risks tilt overwhelmingly to growth rather than inflation."

Tumbling housing prices and waning mortgage credit have pushed up borrowing costs for both banks and consumers, and will probably slow the expansion to a 1.7 percent annual rate in 2008, according to the median forecast of 80 economists in a Bloomberg News survey.

Unemployment rose in August to a five-year high of 6.1 percent and payrolls have fallen for eight straight months.

"The weakness in fundamentals underlying consumer spending suggest that household expenditures will be sluggish, at best, in the near term," the Fed chairman said. "The continuing decline in house prices reduces homeowners' equity and puts continuing pressure on balance sheets of financial institutions."

Bernanke said construction of commercial office buildings and business spending on equipment and software are likely to slow. Declining growth abroad could reduce the lift the U.S. economy received from exports in the first half, he said.

"If financial conditions fail to improve for a protracted period, the implications for the broader economy could be quite adverse," Bernanke said.

Bernanke also said slowing growth should help moderate inflation pressures. The consumer price index rose 5.4 percent for the year ending in August.

"The inflation outlook remains highly uncertain," he said. "The upside risks to inflation remain a significant concern."

Responding to questions from lawmakers, Bernanke said that should the rescue succeed and spur an economic recovery, the Fed may raise interest rates sooner than it otherwise would. For the plan itself, "I don't expect any effect on inflation," he said.

Bernanke Tuesday told the Senate Banking Committee in a joint appearance with Paulson that lawmakers should pass the rescue plan quickly.

In a worsening credit crisis, "people cannot borrow to buy a car, to send a student to college, to buy a house," Bernanke told the House committee Wednesday. Scant lending harms "people at the lunch bucket level."

Fed officials have so far failed to stem the credit crisis even after the steepest rate cuts in two decades and interventions in Bear Stearns Cos. and American International Group Inc. this year.

The Fed has also pumped billions of dollars into banks to try to restore liquidity, while invoking extraordinary powers to loan to securities firms.

The Treasury this month took over Fannie Mae and Freddie Mac as the turmoil engulfed the two largest mortgage finance companies.

Lawmakers have balked at approving the Treasury's proposal to buy illiquid assets from financial institutions without changes. Republicans resisted the plan's size and scope and Democrats demanded support for homeowners and limits on executive pay.