Fed chief sees economy rebounding by midyear

WASHINGTON —The combination of a fiscal stimulus package and successive interest-rate cuts should spark an economic rebound by the middle of the year, Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson testified Thursday.

Addressing an often-testy Senate Banking Committee, both men also rejected criticism that they were slow to respond to an unfolding economic crunch.

‘‘At present, my baseline outlook involves a period of sluggish growth, followed by a somewhat stronger pace of growth starting later this year as the effects of monetary policy and fiscal stimulus begin to be felt,’’ Bernanke said.

Financial institutions are sitting on capital to shore up their balance sheets and aren’t lending freely, he said. This tightened lending is beginning to affect everything from student loans to the municipal bonds that help pay for highway and bridge construction.

As a consequence, the Fed chief said, ‘‘the outlook for the economy has worsened in recent months, and the downside risks to growth have increased.’’

Bernanke made it clear that the Fed could move quickly to cut interest rates again if conditions deteriorate further.

‘‘A critical task for the Federal Reserve over the course of this year will be to assess whether the stance of monetary policy is properly calibrated,’’ he said, alluding to more reductions.

In response to Wall Street volatility and a slowing economy, the Fed cut its benchmark federal funds rate by 1.25 percentage points in January — and by 2.25 percentage points since last September — bringing it down to 3 percent. The effects of monetary policy are slow to be noticed, so most of the benefit from lower borrowing costs won’t be felt until later in the year.

When Paulson was asked whether he thought that the nation would fall into recession, he answered: ‘‘I believe we are going to continue to grow, albeit at a slower rate.’’

Recession fears have heightened on a bevy of bad economic news, including sluggish fourth-quarter economic growth, negative job growth in January, sluggish retail sales and a much sharper than expected decline in nonmanufacturing business activity.

Wall Street wasn’t impressed with the latest read by economic regulators.

The Dow Jones Industrial Average closed down 175.26 points to 12,376.98; the S&P 500 was off 18.35 points to 1348.86 and the Nasdaq finished down 41.39 points to 2332.54.

Markets shrugged off Bernanke’s optimism and focused instead on a hearing Thursday by the capital markets subcommittee of the House Financial Services Committee. There, Democratic New York Gov. Eliot Spitzer warned that a ‘‘financial tsunami’’ awaits if there’s a ratings downgrade of bond insurers that underwrote policies on roughly $2.4 trillion in debt, much of it mortgage bonds at the heart of today’s credit-market turmoil.

His insurance superintendent, Eric Dinallo, has led a public-private effort to shore up bond insurers in hopes of averting downgrades that would force many investors to sell off any bonds no longer considered top-rated and lead to more losses on Wall Street.

Hoping to offset some of the housing and credit-market woes, Congress last week passed a $168 billion economic stimulus package of tax rebates for consumers and tax relief for businesses. Most Americans will start to receive tax rebates of $300 to $600 in mid-May.

Bernanke said he expected that this action would make for a ‘‘more resilient’’ economy. Paulson described it as a ‘‘temporary boost’’ to help weather the housing slump.

But Alabama Republican Sen. Richard Shelby equated the rebates ‘‘to pouring a glass of water in the ocean and hoping it will make a difference.’’ Tennessee Sen. Bob Corker, who’s also a Republican, added, ‘‘sprinkling $160 billion around the country and asking people to spend it quickly to me was not a solution worth debating or passing.’’

Democrats weren’t any friendlier.

New Jersey Sen. Robert Menendez accused the panelists of being asleep at the switch as housing woes spread to the broader economy.

‘‘Instead of warning bells . . . we had timid responses. I think we’ve seen what the let’s-wait-and-see approach has produced and where it’s gotten us,’’ he said, adding that ‘‘what we got was a snooze button. We have been behind the curve.’’

Paulson responded that the Bush administration has moved aggressively, and he pushed back at senators who accused him of glossing over economic problems.

‘‘I didn’t create this problem. I am working to do something about it,’’ he shot back at one point.

In response to Menendez’s bleak economic assessment, Paulson said, ‘‘If you are trying to talk up the economy, I’d hate to see you talk it down.’’ The senator answered: ‘‘I’m just trying not to hide my head in the sand.’’

Much of what ails the U.S. economy isn’t easily addressed by a stimulus plan or interest rate cuts. An excessive run-up in home prices now is unwinding across the nation. And investors have lost confidence in the complex financial instruments that bundled mortgages into bonds for sale to investors, many overseas. This lack of confidence has extended to the companies that issued insurance policies on the difficult-to-understand financial instruments.