"It would probably knock the recovery back into a recession and cost a lot of jobs, and would greatly delay the recovery that we're hoping to facilitate," said Bernanke at the end of two hours of testimony Tuesday before the Senate Banking Committee.
But Bernanke said lawmakers must go beyond the year-end issues and come up with on a plan to shrink the budget deficit. Otherwise, the United States could suffer a financial crisis marked by rising interest rates.
"We might face ... a financial crisis where interest rates would rise, as we're seeing now in Europe and that would feed through to other interest rates like mortgages and other kinds of rates. And it would be very costly to our economy," he said.
Bernanke was giving his midyear report on the state of the economy. And that wasn't pretty either. It's growing modestly but has weakened in recent months, he said. Job growth has slumped, manufacturing has weakened and consumers have lost confidence and have cut back on spending.
The Fed is prepared to take further action if growth doesn't improve. Bernanke provided no clues about what steps the Fed might take or whether any action was imminent.
But Bernanke noted that there is only so much the Fed can do
If Congress doesn't take action by the end of the year, a package of tax cuts adopted during George W. Bush's administration expire while deep spending cuts kick in. If that happens, the economy would go over a "fiscal cliff."
Congress would help the economy by resolving the issue well before the year ends. "Doing so would help reduce uncertainty and boost household and business confidence," he said.
An election-year standoff has immobilized Congress. Republicans want deeper spending cuts while extending the Bush-era tax cuts for all income classes. Democrats want to extend the tax cuts for middle- and lower-class Americans, while allowing them to expire for those in the higher-income brackets.
Bernanke stopped short of telling Congress how to proceed. He challenged them to think broadly.
"Congress is in charge here, not the Federal Reserve," he said.
Stocks rose sharply despite Bernanke's grim assessment. The Dow Jones industrial average climbed more than 90 points, and broader indexes also gained.
Investors had hoped Bernanke would signal another round of bond purchases, to drive down long-term interest rates and encourage more borrowing and spending. But they seemed to shrug off the downbeat outlook and focused on stronger earnings reported by Mattel, Coca-Cola and other big companies.
At least one senator implored Bernanke to take action now.
"Given the political realities of this year's election, I believe the Fed is the only game in town," Sen. Charles Schumer, a New York Democrat, said. "I would urge you, now more than ever, to take whatever actions are warranted."
"So get to work, Mr. Chairman," Schumer added.
Even if the Fed announces another round of bond purchases, some economists question how much that would help. They note that mortgage rates and other key interest rates are already at record-low levels.
The economy was already sputtering when the Fed's policymaking committee last met June 19-20. At that meeting, the Fed decided to extend a program that shifts its bond portfolio to try to lower long-term interest rates. The Fed also reiterated its plan to keep its key short-term interest rate near zero until at least late 2014.
Minutes of the June meeting show that Fed officials were open to taking further action — but were divided over whether the economy needs help now.
Since then, the government has reported that job growth slowed sharply in the April-June quarter — to 75,000 a month from 226,000 a month from January through March. The unemployment rate stayed at 8.2 per cent in last month.
Former Fed official Roberto Perli, managing director at the research firm International Strategy & Investment, doubts the Fed will take action at its next meeting July 31-Aug. 1, preferring to wait for more evidence of where the economy is headed.
But if growth and job creation continue to weaken, he says, Fed policymakers might unveil another round of bond purchases at its Sept. 12-13 meeting.