Economy faces risks, not recession: Bernanke

WASHINGTON (Reuters) - Federal Reserve Chairman Ben Bernanke told lawmakers on Thursday the U.S. economy did not appear headed for recession, but warned growth could prove weaker than expected and inflation higher.

"Our assessment is for slower growth, but positive growth, going into next year," Bernanke said as he delivered a status report on the economy's health to the congressional Joint Economic Committee.

The Fed chairman said the economy is likely to experience "noticeably" slower growth in the final three months of the year than the robust 3.9 percent annual rate of the third quarter, saying a housing slump looked set to intensify and consumer and business spending could slow.

However, he said the U.S. central bank expects the world's largest economy to regain steam by the middle of next year as housing and financial markets stabilize.

At the same time, Bernanke said credit market strains have persisted since the Fed's last meeting on October 30-31, when it followed up a half-percentage-point interest rate cut made in September with another quarter-point trim.

Recent sharp gains in oil prices have renewed upward pressure on inflation and may further crimp economic activity, he added.

IN A BOX

Bernanke's cautionary notes on the growth outlook weighed on stock prices and the dollar and gave a lift to prices for U.S. government debt, as traders saw it suggesting a greater likelihood the Fed would cut benchmark overnight rates again from their current 4.5 percent.

The Dow Jones industrial average .DJI was down as much as 1 percent, while the tech-heavy Nasdaq .IXIC slid as much as 3 percent, hurt by Bernanke's remarks and news that tech bellwether Cisco Systems Inc (CSCO.O) had seen a big drop in orders from U.S. banks.

Worries the economy may be sinking toward a recession boosted betting in futures markets that the Fed will cut rates by a quarter-percentage point at its next meeting on December 11 to as high as 98 percent from 70 percent late on Wednesday.

Some analysts said Bernanke's testimony suggested a willingness at the Fed to consider more rate cuts, while others saw it as finely balanced between concerns on growth and concerns over the potential inflation could quicken.

"They are pulled in two directions," said Christopher Low, chief economist for FTN Financial in New York. "They are worried about the economy. They are worried about inflation. Bernanke is in a box and it is getting smaller."

At its most recent policy-setting meeting, the central bank said downside risks to growth were roughly in balance with upside risks for inflation, a statement that led many observers to believe the Fed would hold off lowering rates further.

Bernanke reiterated that view on Thursday, citing increase in the cost of oil and other commodities and a drop in the value of the dollar.

"These factors were likely to increase overall inflation in the short run and, should inflation expectations become unmoored, had the potential to boost inflation in the longer run as well," he said, adding it could be "very costly" if the Fed had to beat back a rise in inflation.

DOLLAR'S IMPACT ON PRICES

Bernanke played down concerns that the slumping dollar, which slipped to near record lows against the euro on Thursday, was losing its place as the world's reserve currency, but acknowledged it could put upward pressure on U.S. inflation.

"We're going to make sure that the inflationary impact that may come from the weakening dollar is not passed into broader prices," he said.

Bernanke also said delinquencies among holders of subprime mortgages were likely to rise. A sharp rise in home foreclosures could weaken the already struggling housing market and damage the broader economy, he warned.

While Bernanke said tighter credit following market turbulence would likely restrain economic growth, the economy's underlying strength should get it through this stormy period.

"We think that by the spring of early next year, as these credit problems resolve and as, we hope, the housing market begins to find a bottom ... the broader resiliency of the economy, which we are seeing in other areas outside of housing, will take control and will help the economy recover to a more reasonable growth pace," he said.

(Reporting by Mark Felsenthal)