July 16 (Bloomberg) -- Forget about any near-term rate increases, even if we led you in that direction.

That was the essence of Federal Reserve Chairman Ben Bernanke's semi-annual testimony to Congress on the economy and monetary policy.

The effect of what he said -- actually, what he didn't say -- was to lower expectations of any rate increases this year. Specifically, Bernanke said the risks of higher inflation and slower growth are balanced, if you can call it that. They just aren't balanced in a way that implies an optimal policy setting that lets policy makers sleep well at night.

Recent speeches and testimonies by Fed officials had convinced traders and investors that the benchmark overnight rate, currently at 2 percent, could be at 2.75 percent by year- end. The statement released after the meeting just three weeks ago gave greater weight to inflation concerns.

``Although downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased,'' the Fed said on June 25.

One month ago, there was zero chance the funds rate would still be at 2 percent following the September, October and December meetings of the Federal Open Market Committee (FOMC), based on the prices of fed funds futures contracts. Yesterday, those contracts were signaling overwhelming odds of no change in the benchmark rate by year-end.

Accelerated Expectations

Market expectations for an aggressive reversal in official interest rates never made much sense. True, the funds rate is too low relative to inflation. The Fed didn't put it there for the purpose of restraining price pressures. Policy makers cut rates because the financial system wasn't functioning and the economy was showing cracks.

Fed officials probably wish they had come up with the idea of emergency lending facilities for banks and primary dealers -- lending directly to those who need it -- before slashing the funds rate to levels that stoked the last housing bubble.

They didn't, and it's too late (or early) to normalize official interest rates. The economy and financial system are fragile. The once-``contained'' (officials' assessment, not mine) subprime crisis has leached into every sector of the economy. Just last weekend, government officials had to think the unthinkable: the possible failure of Fannie Mae and Freddie Mac, two government-sponsored enterprises that own or guarantee $5.2 trillion of the $12 trillion of mortgages in the U.S.

In another weekend announcement, the Treasury and Fed offered the GSEs a liquidity backstop, via the Fed's discount window and bigger credit line from the Treasury. Treasury Secretary Hank Paulson also asked Congress to approve a provision that would allow the government to purchase equity in the two companies. The hope is the existence of a backstop will preempt its use.

Credit Crunch

Outside of the two mortgage-finance agencies, credit is getting more expensive and harder to get. The assets of commercial banks fell 5.8 percent annualized in the three months ended June, the second-largest contraction in the 60-year history of the data, according to Paul Kasriel, chief economist at the Northern Trust Corp. in Chicago.

Yesterday's testimony had something for everyone.

For Congress, Bernanke provided the standard report card on the U.S. economy: housing, falling; employment, falling; business spending, slowing; consumer spending, ``holding up somewhat better than might have been expected;'' exports, strong; inflation, elevated.

He walked the senators through the high and low points of the year, from the near-collapse and rescue of Bear Stearns Cos. in March to the emergency measures by the U.S. Treasury and the Fed to shore up Fannie Mae and Freddie Mac last weekend. He briefed his congressional overseers on new standards for all mortgage lenders designed to prevent abuses.

Column A and B

Investors tend to fast forward through the Fed chief's economic bill of health and focus on anything that has policy implications. For them, Bernanke could have reduced his testimony to two columns outlining the risks as the Fed sees them:

     Risks to Growth               Risks to Inflation

     High energy prices            High energy prices
     Tighter credit conditions     Increase in inflation
     Financial market stress            expectations
     Bank losses                   Inflation already too high
     Contraction in housing        Weak Dollar
     Non-specific headwinds

We can strike higher energy prices because the entry appears in both columns (double entry bookkeeping or twice the risk?). Non-specific headwinds is in there just for fun, a carry-over from Bernanke's nautically minded predecessor.

Netting out the columns, it seems the risks are both balanced and bad.

(Caroline Baum, author of ``Just What I Said,'' is a Bloomberg News columnist. The opinions expressed are her own.)

To contact the writer of this column: Caroline Baum in New York at cabaum@bloomberg.net.

Last Updated: July 16, 2008 00:01 EDT