Federal Reserve Chairman Ben Bernanke warned this afternoon that mortgage delinquencies and foreclosures are likely to rise.
"This situation calls for a vigorous response," Mr Bernanke said in a speech, referring to government and private-sector initiatives to slow the rate of home loan failures.
Banks may have to swallow reductions in the principal of some troubled home loans to ward off greater losses that could result from outright default, the Fed chairman said.
"Measures to reduce preventable foreclosures could help not only stressed borrowers but also their communities and, indeed, the broader economy," he said.
US government bond prices shed early losses and turned higher on Mr Bernanke's comments.
Mr Bernanke's comments come as the central bank grapples with the twin dilemmas of a slowing economy and rising inflation. US economic growth slowed to a sluggish 0.6 per cent at the end of 2007, and hiring declined in January. But inflation rose 4.1 per cent in 2007, the largest 12-month rise since 1990.
Housing difficulties now differ from past housing market slumps because of the large number of homeowners who owe more on their home loans than their homes are worth, Mr Bernanke said.
"In this environment, principal reductions that restore some equity for the homeowner may be a relatively more effective means of avoiding delinquency and foreclosure than reducing interest rates on troubled home loans," he said.