[ForexNews]

Fed Chairman Bernanke testified to the House Budget Committee about the economic outlook and the importance of fiscal sustainability in the face of a widening budget deficit. He argues that the debt-to-GDP ratio is set to reach 70% in 2011 from 40% before the onset of the financial crisis; this would be the highest reading since the early 1950s. As such, the Treasury must plan to restore fiscal balance since the government cannot borrow "indefinitely" to meet those demands. He warns that unless we "demonstrate a strong commitment to fiscal sustainability in the longer term we will have neither financial stability nor healthy economic growth."

He attributes some of the recent rise in longer-term Treasury yields to growing concerns about large federal deficits. In addition, he believes that rising yields may reflect greater optimism about the economic outlook, a reversal of risk aversion and technical factors related to the hedging of mortgage holdings. Although he gave an explanation for higher rates, analysts do not believe it means he is complacent about rising borrowing costs. Indeed, he noted earlier in the speech that a "continuing gradual repair of the financial system and an associated improvement in credit conditions" is necessary for the economic recovery.

On the economic outlook, he reiterated that the pace of economic contraction appears to be slowing, and he expects growth by the second half of the year. However, he expects the rate of economic activity to remain below its longer-term potential for awhile as the recovery only gains "gradual momentum." On prices, he anticipates that inflation will remain low given slack in the economy.

In the Q&A, Bernanke was asked about the exit strategy. He argued that the Fed will be able to unwind the easing policy and reduce its balance sheet when it deems appropriate. He notes three methods: 1) decline in short-term lending programs either naturally due to falling demand (already occurring) or by shutting the programs; 2) adjust the rate paid on reserves; 3) reverse repurchase agreements. He is confident the Fed will be able to exit without inflationary consequences. Bernanke was also asked if the Fed plans to "monetize the debt", and by extension "inflate away the debt" by buying Treasuries. Bernanke said he has no intention of doing so and that once the Fed has completed its current Treasury-buying program, it will still hold a smaller volume of Treasuries than before the crisis.