By Mark Felsenthal and Alister Bull
WASHINGTON (Reuters) - Federal Reserve Chairman Ben Bernanke on Tuesday said the outlook for the long-suffering U.S. economy was improving but that supportive policies would be needed for some time to prevent rising unemployment from undercutting recovery.
Delivering the Fed's semiannual report on the economy to Congress, Bernanke also sought to dispel concerns the central bank's aggressive monetary easing could end up fueling inflation, saying he was confident the central bank could pull back its extraordinary stimulus when the time was right.
"Better conditions in financial markets have been accompanied by some improvement in economic prospects," Bernanke told the House of Representatives Financial Services Committee. "Despite these positive signs, the rate of job loss remains high."
While signs of stabilization in housing and household spending have emerged, unemployment was likely to remain uncomfortably high into 2011 and could sap fragile consumer confidence, he warned.
"The (Fed) believes that a highly accommodative stance of monetary policy will be appropriate for an extended period," Bernanke said.
The Fed chief's sober assessment of a sluggish recovery weighed on stocks and gave safe-have bonds a boost. The blue-chip Dow Jones industrial average gave up initial gains to trade lower, while prices for government debt rose and the U.S. dollar extended losses against the yen.
"The Fed has zero intention of tightening monetary policy any time in the near future. They want to keep the conditions in place to sustain this fragile economic recovery," said Boris Schlossberg, director for currency research at GFT Forex in New York.
'WE HAVE THE NECESSARY TOOLS'
The Fed has cut interest rates to almost zero and doubled the size of its balance sheet to around $2 trillion as it pumped money into the economy to fight a severe recession after a financial panic last year cracked global credit markets.
Some economists, including some policy-makers, have worried that this dramatic expansion of Fed liquidity and lending may have sown the seeds for inflation to blossom as the recovery gains traction.
Bernanke, however, said the central bank had an array of weapons at its disposal to withdraw monetary stimulus when the time was right, even with a bloated balance sheet.
"The (Fed) has been devoting considerable attention to issues relating to its exit strategy, and we are confident that we have the necessary tools to implement that strategy when appropriate," he said, echoing comments he made in an article published late on Monday on the Wall Street Journal's website.
"Should economic conditions warrant a tightening of monetary policy before this process of unwinding is complete, we have a number of tools that will enable us to raise market interest rates as needed," Bernanke said.
Paying interest on the reserves banks hold at the Fed -- a tool used by other central banks -- is chief among these devices, he said. By raising the amount of interest it pays, the Fed can encourage banks to park excess cash at the central bank.
The Fed's monetary policy report also detailed a number of other measures that Bernanke also outlined in his newspaper piece.
The report said the Fed could arrange so-called reverse repurchase agreements with financial firms. The Fed would sell securities from its portfolio, taking cash out of the system, with an agreement to buy them back later at a higher price.
It could also offer "term deposits" similar to certificates of deposit to banks. Bank funds held at the Fed in such instruments would not be available for lending.
In addition, the Treasury Department could issue securities and leave the funds on deposit with the Fed, or the Fed could sell some of the securities it has accumulated.
(Reporting by Mark Felsenthal and Alister Bull; Editing by Andrea Ricci and Tim Ahmann)
