The Federal Reserve now estimates that the country's gross domestic product will expand "sluggishly" over the next two years, according to Fed Chairman Ben Bernanke, who warned members of the Senate Banking Committee this morning that "the risk to this outlook remains on the down side" because the housing market might continue to slide and prices for oil and food might continue to rise.

In 2007, consumer prices rose by 4.1 percent, the biggest spike in 17 years. Inflation expectations, as measured by 10-year notes and Treasurys linked to consumer prices, reached 2.56 percent, their highest level since June.

Bernanke told lawmakers that inflation, minus food and gas prices, would "moderate" in 2008, to between 2.1 percent and 2.4 percent, and would continue to fall to a growth rate of between 1.5 and 2 percent in 2010, when he expects the country's output "to pick up" and unemployment to recede.

But in response to a question from committee chairman Chris Dodd (D-Conn.), who asked Bernanke to comment about parallels Dodd sees between what's happening now and what happened in 2001 after the dot-com crash, Bernanke said it was "fair" to say that the United States is in a weaker position now to respond to economic volatility than it was during that earlier period. Bernanke noted that where investors mostly took the biggest hit from the economic troubles in 2001, "consumers are bearing the brunt" of today's downturn because so much of it is tied to the turmoil in the housing, energy, and food markets.

Bernanke was quick to note, however, that he does not anticipate a period of "stagflation," where growth slows, inflation rises, and unemployment increases.

Richard Shelby (R-Ala.), the ranking Republican on the banking committee, asked Bernanke whether the Fed's 225-basis-point cuts in interest rates had limited its ability to address future problems. Bernanke responded by saying that if oil and food prices "stabilize," as he anticipates, "that would be enough to bring inflation down." That led to a discussion about why declining home prices weren't having a greater impact on inflation. Shelby noted that housing accounts for about one-third of the core consumer price index. But Bernanke spoke of the "perverse effect" that results from falling home prices causing higher rental prices when people become more reluctant to purchase houses.

During his comments today, Bernanke said the decline in home prices has created a "sustained disruption" in the credit process, and he predicted that some small banks could fail. But he also believes that the "capital ratios" of larger banks remain "good," although he'd like to see large lending institutions seek more capital from outside sources. (In the fourth quarter, banks negotiated $75 billion in new financing.)

The housing and credit problems, though, are not going to be solved by "temporary palliatives," said Bernanke, who urged lawmakers to redouble their efforts to modernize the FHA and to reform government-sponsored enterprises such as Fannie Mae.

In a mid-morning press conference today, President Bush echoed the Fed Chairman's general sentiments in support of FHA and GSE reform, but further underscored his opposition to the Senate's Foreclosure Prevention Act of 2008.

The proposed legislation is controversial because it would give bankruptcy court judges the authority to reduce a homeowner's mortgage payment, a provision that the bill's co-sponsors say could help 600,000 families. The bill would also allow Housing Finance Agencies to use proceeds from up to $10 billion in mortgage revenue bonds to refinance subprime loans and provide mortgages to first-time home buyers.

"The Senate proposal bails out lenders and speculators," Bush told the national press corps. "It will do nothing to help American families stay in their homes," he added, concluding a brief statement this morning in which the President focused on housing.

The Fed is also being more proactive about preventing foreclosures by tightening lending requirements. In December, the Fed's board issued new guidelines that, if approved, would establish lending standards that would prohibit lenders from making higher-priced loans without relying on third-party income documentation; would require them to establish escrow accounts for deposits; and would prohibit deceptive marketing and "coercion" from appraisers on lenders. The Fed is currently conducting compliance reviews on lenders.