Federal Reserve Chairman Ben Bernanke on Tuesday urged Congress and the Obama administration to strike a budget deal to avert tax increases and spending cuts that could trigger a recession next year.
Without a deal, the measures known as the "fiscal cliff" will take effect in January.
Bernanke also said Congress must raise the federal debt limit to prevent the government from defaulting on Treasurys debt. Failure to do so would impose heavy costs on the economy, he said. Bernanke said Congress also needs to reduce the federal debt over the long run to ensure economic growth and stability.
Uncertainty about all these issues is likely holding back spending and investment and troubling investors, the Fed chairman said in a speech to the Economic Club of New York.
Resolving the fiscal crisis would prevent a sudden and severe shock to the economy, help reduce unemployment and strengthen growth, he said. That could make the new year "a very good one for the American economy," he said.
"A stronger economy will, in turn, reduce the deficit and contribute to achieving long-term fiscal sustainability," Bernanke told the group.
When asked during a question and answer session after the speech whether the Fed could soften the impact of the fiscal cliff, Bernanke was firm in his warning.
"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," Bernanke said.
Bernanke also said the severity of the Great Recession may have reduced the U.S. economy's potential growth rate. He didn't say by how much or how long slower-than-normal growth might persist.
Over the long run, the U.S. economy has grown an average of about 2.5 percent each year. Economists predict growth in the July-September quarter will be revised up to an annual rate of around 3 percent, above the government's initial 2 percent estimate. But they think the economy is slowing to an annual growth rate below 2 percent in the October-December quarter — too slow to make much of a dent in unemployment.
Bernanke said several factors have weighed on growth: Long-term unemployment has eroded many workers' skills and led some who have lost jobs to stop looking for one.
Companies have spent less on machinery, computers and other goods, reducing their production capacity. Stricter lending rules and uncertainty about the economy may have discouraged would-be entrepreneurs from starting more companies, the Fed chairman said.
Even assuming the economy's potential growth has declined, Bernanke said that unemployment, now at 7.9 percent, is abnormally high. He suggested, though, that the drags on economic growth should fade as the economy heals.
By the end of December, just as the fiscal cliff nears, the federal government is expected to hit its borrowing limit. Treasury Secretary Timothy Geithner has said he will resort to the same maneuvers he used during the last debt standoff in 2011 to prevent the government from defaulting on its debt.
But these maneuvers would buy only a few weeks' time, until late February or early March, before the government would face the prospect of a first-ever debt default.
After the last debt standoff in the summer of 2011, Standard & Poor's downgraded the government's credit rating on long-term securities one notch from the highest level of AAA to AA+. It was the first ever downgrade of U.S. government debt.
After the presidential election, Fitch Ratings said Obama would need to quickly reach a budget agreement with Congress over the fiscal cliff or risk losing Fitch's AAA rating on U.S. debt.
It's unclear what, if anything, the Fed could do to cushion the economy from the fiscal cliff beyond the bond purchases it's already making to try to lower long-term borrowing rates and stimulate spending.
The minutes of the Fed's last policy meeting suggest that it will likely unveil a bond buying program in December to try to drive down long-term rates. The new purchases would replace a bond-buying program that expires at year's end.
Most analysts said Bernanke's comments suggest that is likely.
A new bond buying program would come on top of a program the Fed launched in September to buy $40 billion a month in mortgage bonds to try to reduce long-term interest rates and make home buying more affordable. That program represented the Fed's third round of major bond purchases to expand its holdings.
Fed officials also announced at the September meeting that they planned to keep the Fed's benchmark short-term interest rate near zero through mid-2015. This rate for overnight loans has been at a record low since December 2008.