Bernanke: Markets under stress, outlook uncertain

By Emily Kaiser and Mark Felsenthal

WASHINGTON (Reuters) - A weakening housing market, a strained banking system, and rising oil prices threaten the U.S. economy, and restoring financial market stability is a top priority, Federal Reserve Chairman Ben Bernanke said on Tuesday.

It was a gloomier assessment than the central bank's policy-setting panel gave in late June, when it said risks to economic growth had diminished somewhat.

Bernanke, in his semi-annual testimony on economic conditions to lawmakers on Tuesday, acknowledged that financial markets had grown increasingly anxious in recent weeks, particularly over the financial condition of mortgage finance companies Fannie Mae and Freddie Mac.

He stressed that the outlook for economic growth and inflation was unusually uncertain. Investors took that as a signal that the Fed would keep interest rates unchanged at least through August, and perhaps through the end of the year.

"The possibility of higher energy prices, tighter credit conditions, and a still-deeper contraction in housing markets all represent significant downside risks to the outlook for growth. At the same time, upside risks to the inflation outlook have intensified lately," he said.

Bernanke said the slumping housing market was "the most critical and central issue that we face," because it held the key to consumer spending as well as banks' financial health.

"The testimony represents a significant retreat and does imply that the Fed will not be moving to hike (interest) rates anytime soon," said Joseph Brusuelas, chief economist with Merk Investments.

Bernanke's comments come just two days after the Treasury Department, in close coordination with the central bank, announced measures to aid Fannie Mae and Freddie Mac, which have been under pressure as the housing market has deteriorated.

In a second hearing before the Senate Banking Committee, Treasury Secretary Henry Paulson said the government-sponsored enterprises "have the potential to pose a systemic risk" to the financial system, and urged Congress to pass legislation creating a stronger regulator.

Paulson, Bernanke and Securities and Exchange Commission Chairman Christopher Cox were testifying at a hastily organized hearing convened to discuss financial issues, including Fannie and Freddie.

INFLATION UP

Stock prices initially tumbled after Bernanke's comments, but recovered later as oil futures suffered their largest one day price fall in 17 years. The U.S. dollar remained weak, after seeing a new record low against the euro overnight, while U.S. Treasury bond yields fell.

In its semi-annual monetary policy report to Congress, the Fed raised its projection for growth in 2008 to a range of 1.0 percent to 1.6 percent from the 0.3 percent to 1.2 percent range it forecast in April, on expectations of stronger consumer spending.

President George W. Bush said the economy was still growing, although he acknowledged that there was "obviously financial uncertainty".

With energy costs rising, the Fed also raised its inflation forecast to a range of 3.8 percent to 4.2 percent, up substantially from its previous 3.1 percent to 3.4 percent projection.