Bernanke: Fed balance sheet not policy obstacle

WASHINGTON (Reuters) - The U.S. central bank will be able to raise interest rates when the time comes to head off inflation, even with a bloated balance sheet, Federal Reserve Chairman Ben Bernanke said on Wednesday.

Bernanke told the House of Representatives' Budget Committee that deciding when to start withdrawing the money the Fed has pumped into the economy to stem its downward spiral would be a tough call to make, but he expressed confidence inflation would be averted.

"We want to be sure that we'll be able to remove accommodation at an appropriate time and an appropriate speed to ensure that we don't have an inflation risk down the road," Bernanke said.

"It's not going to be an easy call but we'll have to balance the risk on both sides -- not going too soon and stunting the (recovery) and not going too late and having a bit of inflation. But we will get price stability after we get out of this recession."

The Fed has pumped over a $1 trillion into the economy, partly through the purchases of Treasury and mortgage-related debt, in a bid to restore lending and end a recession that began in December 2007.

Some financial market participants are worried the Fed won't be able to exit from its aggressive monetary easing in a timely and effective way.

Bernanke said the Fed could bump borrowing costs higher by raising the interest rate it pays on reserves banks hold at the central bank, and it could also tighten policy by conducting reverse repurchase operations in which it would withdraw liquidity from the banking sector.

In addition, "if worst came to worst," the Fed could also sell assets, Bernanke said, adding that that was not a big part of the central bank's current exit plan.

Bernanke also said there were "other possibilities" that could be discussed with Congress. While he didn't elaborate, other ideas have included the Fed issuing its own debt to help manage its expanding balance sheet or raising the federal debt ceiling so the U.S. Treasury could issue debt on behalf of the Fed.

Bernanke said the U.S. central bank's policy-setting Federal Open Market Committee had been worried for a while that the economic downturn would be so severe it would cause deflation -- a potentially harmful broad-based decline in prices.

Those worries, however, were easing, he said.

"We will ensure price stability. I think the fear of deflation has receded somewhat." he said. "The question is will we be able to raise interest rates given the size of our balance sheet. My answer is yes."

(Reporting by Lucia Mutikani; Editing by Neil Stempleman)