Ben Bernanke, the chairman of the Federal Reserve, today publicly acknowledged for the first the the possibility of a contraction, saying that the economic outlook has weakened significantly in recent months.

He also defended the rescue of Bear Stearns, saying that the damage caused by the firm's collapse "could have been severe and extremely difficult to contain."

In testimony before the Joint Economic Committee, the Fed chairman said that the economy "Will not grow much, if at all, over the first half of 2008," he said, and "could even contract slightly."

In the question and answer session that followed his testimony, Bernanke acknowledged that "a recession is possible."

The Fed expects the economy to strengthen in the second half of the year. "However, in light of the recent turbulence in financial markets, the uncertainty attending this forecast is quite high and the risks remain to the downside."

Bernanke added that "inflation has also been a source of concern," pointing to the sharp rise in global commodities prices.

The Calculated Risk blog notes that there was "nothing really new in Bernanke's economic outlook, but historically when the Fed chairman starts talking about the possibility of a recession, the economy is already in a recession."

On the Bear rescue, Bernanke said that the Fed and other government agencies were informed that Bear's liquidity position "had significantly deteriorated and that it would have to file for Chapter 11 bankruptcy the next day unless alternative sources of funds became available."

Questioned about why the government bailed out Bear Stearns but not troubled homeowners, Bernanke denied that it was a bailout and objected to the "false dichotomy" in contrasting Bear's fate with homeowners.

"We did not bail out Bear Stearns," he said, noting that shareholders took a significant loss. The rescue, he said was "necessary to preserve the integrity of the American financial system.” 

 "Normally, the market sorts out which companies survive and which fail, and that is as it should be. However, the issues raised here extended well beyond the fate of one company. Our financial system is extremely complex and interconnected, and Bear Stearns participated extensively in a range of critical markets. With financial conditions fragile, the sudden failure of Bear Stearns likely would have led to a chaotic unwinding of positions in those markets and could have severely shaken confidence. The company's failure could also have cast doubt on the financial positions of some of Bear Stearns' thousands of counterparties and perhaps of companies with similar businesses. Given the current exceptional pressures on the global economy and financial system, the damage caused by a default by Bear Stearns could have been severe and extremely difficult to contain. Moreover, the adverse effects would not have been confined to the financial system but would have been felt broadly in the real economy through its effects on asset values and credit availability."