By Jonathan Spicer and Leah Schnurr
NEW YORK (Reuters) - Federal Reserve Chairman Ben Bernanke said on Tuesday that 2013 could be a "very good year" for the U.S. economy if politicians can strike a quick deal to avoid the so-called fiscal cliff.
The powerful central bank chief said a credible long-term framework to put the federal budget on a sound path was needed, but warned against drastic action that would harm the recovery.
He repeated a warning that failing to halt the fiscal cliff's $600 billion in expiring tax cuts and government spending reductions could lead to recession, and said worries over how budget negotiations will be resolved were already damaging growth.
"Such uncertainties will only be increased by discord and delay," he told the Economic Club of New York. "In contrast, cooperation and creativity to deliver fiscal clarity - in particular, a plan for resolving the nation's long-term budgetary issues without harming the recovery - could help make the new year a very good one for the American economy."
Bernanke said it appeared likely there would be some tightening of U.S. fiscal policy next year, and that the Fed's bond purchases would help offset that drag. But he sounded a note of caution on the Fed's powers.
"The ability of the Fed to offset headwinds is not infinite," he said. "In the worst-case scenario where the economy goes off the broad fiscal cliff ... I don't think the Fed has the tools to offset that."
U.S. stocks gave up gains as Bernanke spoke, with the Dow Jones industrial average trading 43 points lower in mid-afternoon.
Bernanke appeared to be dangling the prospect of a stronger economy before Congress as an added incentive for lawmakers to strike a deal.
"I do think there is important potential for the economy to strengthen significantly if there is a greater level of security and comfort about where we are going as a country," he said.
The Fed chief even joked about his own research into the effect of uncertainty on investment spending.
"I concluded it is not a good thing, and they gave me a PhD for that," he said to laughter.
COUNT ON THE FED
The economy grew at a tepid 2 percent annual rate in the third quarter, and economists expect the final three months of the year will be even weaker. The U.S. unemployment rate remains elevated at 7.9 percent, which Bernanke said was still well above levels the Fed thinks are achievable without sparking waged-related price pressures.
Bernanke reiterated the U.S. central bank's guidance that it expects to keep benchmark interest rates near zero until at least mid-2015, but offered few clues as to how the Fed might tweak its bond-purchase program at the start of next year.
"We will want to be sure that the recovery is established before we begin to normalize policy," he said.
U.S. central bank officials have been debating setting numerical guideposts for policy, and Bernanke said this was a promising path for the Fed's communications strategy.
The Fed has held overnight rates near zero since December 2008 and has bought about $2.3 trillion in securities in a so-called quantitative easing of monetary policy to drive other borrowing costs lower.
In its third round of quantitative easing, or QE3, the Fed vowed in September to buy $40 billion in mortgage-backed bonds per month and to continue purchasing securities until there is substantial improvement in the outlook for jobs creation.
Despite worries that the Fed's bloated balance sheet could cause inflation, Bernanke said this is not an immediate concern given restraints on wages and subdued measures of inflation expectations.
Bernanke said it was too soon to assess the impact of the Fed's latest round of monetary easing, but he pointed to research showing prior waves of asset buys were effective in bolstering the frail economy.
The Fed chief said the 2007-2009 financial crisis may have temporarily lowered the U.S. economy's potential rate of growth, partly explaining the recovery's unusual sluggishness.
But he said a series of "headwinds" facing the economy appeared to be a more important cause, citing the damage to the housing sector and mortgage markets, and a sharp tightening in credit.
Those impediments appear to be fading, he said. The U.S. housing market has shown "some clear signs of improvement," and "gradual and significant progress" had been made toward moving toward more normal financial conditions, Bernanke said.
Even so, he warned that a third headwind, U.S. fiscal policy, could intensify in coming quarters, with the drag from a tighter federal budget likely to outweigh looser budgets at the state and local level.
(Additional reporting by Alister Bull in Washington; Writing by Pedro Nicolaci da Costa in Washington; Editing by Chizu Nomiyama, James Dalgleish and Leslie Adler)