Bernanke says Fed prepared to help U.S. economy

WASHINGTON (Reuters) - Federal Reserve Chairman Ben Bernanke on Wednesday signaled a readiness to cut interest rates again to prevent further damage to the weak U.S. economy, even as he took note of rising inflation risks.

Delivering the Fed's semiannual report on the economy to Congress, Bernanke made clear the central bank was worried a deepening housing slump, softening jobs market and tighter credit could dim an already bleak economic outlook.

"It is important to recognize that downside risks to growth remain," Bernanke told the House of Representatives' Financial Services Committee.

"The (Fed) will be carefully evaluating incoming information bearing on the economic outlook and will act in a timely manner as needed to support growth and to provide adequate insurance against downside risks," he said.

The central bank has lowered overnight interest rates to 3 percent from 5.25 percent in five steps since mid-September. Financial markets saw Bernanke's testimony as validating bets on another half-percentage point cut at the Fed's next meeting on March 18.

A Reuters poll of 15 Wall Street dealers found unanimous expectation of a March rate cut. Dealers also now expect the Fed to take interest rates lower during this easing cycle than previously expected.

"They're willing to inject more juice into the system, and that's what they need to do," said Firas Askari, head of currency trading at BMO Capital Markets in Toronto.

A majority of dealers expect rates to be cut to 2.5 percent at the Fed's next meeting. Meanwhile, the median forecast was for rates to fall as low as 2 percent during this cycle, as opposed to a 2.5 percent trough seen in a poll taken February 1.

The dollar hit a record low against the euro on Bernanke's remarks, while bond prices bounced around in reaction to zig-zagging stocks. Stocks traded in and out of negative territory, rallying at one point when a U.S. regulator gave the green light to home finance companies Fannie Mae and Freddie Mac to invest more in the mortgage market, but ending the day little changed.

DELICATE BALANCE

Bernanke said that while the Fed expects inflation to ease, risks that price pressures could stay elevated had ticked up, underscoring the difficult situation policy-makers face.

"The further increases in the prices of energy and other commodities in recent weeks, together with the latest data on consumer prices, suggest slightly greater upside risks to the projections of both overall and core inflation than we saw last month," he said.

A government report last week showed consumer prices rose a steeper-than-expected 0.4 percent in January.

If the public began to doubt the Fed's willingness to keep inflation at bay, it could hurt the central bank's ability to support growth down the road, Bernanke said.

A week ago, the central bank lowered its forecast for 2008 growth by a half-point to between 1.3 percent and 2 percent, while raising its projection for unemployment and inflation.

Bernanke cautioned that monetary policy affects the economy with a lag and said the Fed needed to keep in mind the economy's likely path, as well as the risks it faces.

POLICY LAGS

A report on Wednesday showed single-family home sales tumbled to a 13-year low in January, while median prices posted their biggest year-on-year drop on record. A separate report showed weaker-than-expected demand for long-lasting goods.

Bernanke said information the Fed had reviewed since its last meeting on January 29-30 continued to point to a sluggish economy over the next several quarters. Responding to questions, he said house prices may decline into 2009.

"Given how much ... construction has come down already, I imagine that by later this year it will stop being such a big drag directly" on the economy, he said. "Prices may decline into next year, but we really don't know."

Higher energy prices, lower home and stock market values, and slowing job creation are likely to damp household spending, Bernanke warned. Slower hiring is also likely to weigh on consumers, he added.

Bernanke said financial markets remained strained in the wake of rising mortgage delinquencies and worries about credit quality. However, steps taken by the Fed and other central banks to ease credit market conditions appear to have helped.

Still, financial market stress has kept long-term interest rates -- such as mortgage rates -- at high levels relative to shorter-dated debt, he said.

"Even as the Fed has lowered interest rates and the general pattern of interest rates have declined, pressures in the credit markets have caused greater and greater spreads," offsetting to some degree the impact of the Fed's interest-rate cuts, Bernanke said.

(Additional reporting by Alister Bull, Emily Kaiser and Nancy Waitz; Editing by Leslie Adler)