Financial stress overshadows Fed outlook

By Mark Felsenthal

WASHINGTON (Reuters) - Any hope a less nasty U.S. economic slowdown than feared might free the Federal Reserve to focus on fighting inflation has evaporated with a stock market rout and an unprecedented government show of financial muscle to calm restive markets.

Fed Chairman Ben Bernanke delivers the U.S. central bank's semiannual monetary policy report to Congress on Tuesday and Wednesday, just days after the Treasury and Fed were forced to intervene for the second time in four months to prevent a financial market meltdown.

Bernanke's forecasts for an economy still encumbered by a sharply contracting housing market and soaring food and energy prices is likely to be muddied by uncertainty from financial market turmoil.

The Fed chairman goes before a Senate panel on Tuesday and a House of Representatives committee on Wednesday. Treasury Secretary Henry Paulson and Securities and Exchange Commission Chairman Christopher Cox are also due to appear before the Senate Banking Committee on Tuesday, the panel's chairman, Sen. Christopher Dodd said.

MARKETS WOBBLE

Market instability claimed center stage last week after the failure of mortgage lender IndyMac Bancorp and weekend action by the Treasury Department and the Fed to stand behind embattled mortgage buyers Fannie Mae and Freddie Mac.

"He'll be walking on eggshells, trying to be very careful he doesn't get interpreted the wrong way," said Torsten Slok, an economist for Deutsche Bank.

"Where there's so much uncertainty and after the events of this weekend, taking those risks and those events into account is very difficult," Slok said.

Although a $3 billion Freddie Mac debt sale found ready buyers on Monday, worries about failed loans brought heavy pressure on a wide range of financial firms, including big-name institutions Washington Mutual and National City Corp.

Major stock indexes slid into bear market territory last week as oil climbed to a record above $147 a barrel.

WHAT NEXT?

The U.S. central bank has lowered interbank lending rates to 2 percent since last August, when the credit crunch triggered by widespread delinquencies among subprime mortgages first began to sting broader credit markets.

Policy-makers have left interest rates at that level since April, expecting low rates and a big fiscal stimulus package would put a floor under the economy through the deep housing slump and tight credit. The Fed said at its last rate-setting meeting on June 26 that although there were still risks of growth decelerating, they had diminished somewhat.

It also said the risks that inflation could tick higher had expanded, which analysts read as a baby step toward a tougher anti-inflation stance from a central bank, which had recently been intently focused on the economy's weakness.

The Fed has further hoped a menu of credit offerings to banks and securities firms would help stabilize lending and restore calm to financial markets rattled by losses from delinquent mortgages. Bernanke said last week the Fed is considering keeping open a short-term lending facility for primary dealers in a bid to soothe markets.

For now, reacting to continued market turbulence is likely take precedence over fighting inflation.

"The Fed will have to address the issues of the financial sector again, and this might delay their increasing of interest rates," said Wells Fargo economist Eugenio Aleman.

(Editing by Neil Stempleman and Leslie Adler)

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