By Nick Mann | 8 June 2012

The chair of the Federal Reserve has called on the US government to avoid a ‘sudden and severe’ fiscal contraction due to come into effect next year if politicians fail to agree alternative spending policies.

Ben Bernanke warned that the combination of deep public spending cuts and tax rises would pose a ‘significant threat’ to the country’s economic recovery. The ‘fiscal cliff’ will automatically take effect in January 2013 under the 2011 Budget Control Act, which sets caps on public spending if there is political impasse on tax and spending policies.

‘Preventing a sudden and severe contraction in fiscal policy will support the transition back to full employment, which should aid long-term fiscal sustainability,’ he told the US Congress’ joint economic committee.

‘At the same time, a credible fiscal plan to put the federal budget on a longer-run sustainable path could help keep longer-term interest rates low and improve household and business confidence, thereby supporting improved economic performance today.’

He added that tax policies and spending programmes should be focused on increasing incentives to work and save as well as encouraging investment in workforce skills, stimulating private capital and providing necessary public infrastructure.

Increasing the productivity of the US economy would help to mitigate the impact of the ‘significant adjustment’ in fiscal policies that is needed to address the federal budget deficit, he said.

Bernanke also warned that the eurozone crisis posed ‘significant risks’ to the US financial system and economy. Events in Europe were acting as a drag on exports, affecting business and consumer confidence and putting pressure on the US financial sector.

‘European policymakers have taken a number of actions to address the crisis, but more will likely be needed to stabilise euro-area banks, calm market fears about sovereign finances, achieve a workable fiscal framework for the euro area, and lay the foundations for long-term economic growth,’ he said.

‘As always, the Federal Reserve remains prepared to take action as needed to protect the US financial system and economy in the event that financial stresses escalate.’