By Emily Kaiser and Mark Felsenthal
WASHINGTON (Reuters) - A weakening housing market, astrained banking system, and rising oil prices threaten theU.S. economy, and restoring financial market stability is a toppriority, Federal Reserve Chairman Ben Bernanke said onTuesday.
It was a gloomier assessment than the central bank'spolicy-setting panel gave in late June, when it said risks toeconomic growth had diminished somewhat.
Bernanke, in his semi-annual testimony on economicconditions to lawmakers on Tuesday, acknowledged that financialmarkets had grown increasingly anxious in recent weeks,particularly over the financial condition of mortgage financecompanies Fannie Mae and Freddie Mac.
He stressed that the outlook for economic growth andinflation was unusually uncertain. Investors took that as asignal that the Fed would keep interest rates unchanged atleast through August, and perhaps through the end of the year.
"The possibility of higher energy prices, tighter creditconditions, and a still-deeper contraction in housing marketsall represent significant downside risks to the outlook forgrowth. At the same time, upside risks to the inflation outlookhave intensified lately," he said.
Bernanke said the slumping housing market was "the mostcritical and central issue that we face," because it held thekey to consumer spending as well as banks' financial health.
"The testimony represents a significant retreat and doesimply that the Fed will not be moving to hike (interest) ratesanytime soon," said Joseph Brusuelas, chief economist with MerkInvestments.
Bernanke's comments come just two days after the TreasuryDepartment, in close coordination with the central bank,announced measures to aid Fannie Mae and Freddie Mac, whichhave been under pressure as the housing market hasdeteriorated.
In a second hearing before the Senate Banking Committee,Treasury Secretary Henry Paulson said the government-sponsoredenterprises "have the potential to pose a systemic risk" to thefinancial system, and urged Congress to pass legislationcreating a stronger regulator.
Paulson, Bernanke and Securities and Exchange CommissionChairman Christopher Cox were testifying at a hastily organizedhearing convened to discuss financial issues, including Fannieand Freddie.
INFLATION UP
Stock prices initially tumbled after Bernanke's comments,but recovered later as oil futures suffered their largest oneday price fall in 17 years. The U.S. dollar remained weak,after seeing a new record low against the euro overnight, whileU.S. Treasury bond yields fell.
In its semi-annual monetary policy report to Congress, theFed raised its projection for growth in 2008 to a range of 1.0percent to 1.6 percent from the 0.3 percent to 1.2 percentrange it forecast in April, on expectations of strongerconsumer spending.
President George W. Bush said the economy was stillgrowing, although he acknowledged that there was "obviouslyfinancial uncertainty".
With energy costs rising, the Fed also raised its inflationforecast to a range of 3.8 percent to 4.2 percent, upsubstantially from its previous 3.1 percent to 3.4 percentprojection.
Sluggish economic growth and stubborn inflation has madeBernanke's job more difficult as he tries to restrain inflationwithout tipping the economy into a deep recession.
Pressure has grown, both inside and outside hispolicy-making committee, for the Fed to consider raising thebenchmark federal funds interest rate after cutting it by 3.25percentage points to 2.0 percent since mid-September.
Shortly before Bernanke testified, government reportsunderlined the dilemma. Sales at retail stores barely edged upin June but producer prices, which reflect wholesale inflation,jumped a larger-than-expected 1.8 percent, while the annualrate rose to 9.3 percent, its highest in 27 years.
News from the corporate arena was no more reassuring.General Motors, struggling with declining vehicle sales, saidit will cut 20 percent of its salaried work force, whileKimberly-Clark cut its profit outlook because of high energycosts.
Bernanke said the Fed's efforts to date, including theinterest rate cuts and a series of new lending facilities forbanks, had had a positive effect but the economy still faced"numerous difficulties."
"Many financial markets and institutions remain underconsiderable stress, in part because the outlook for theeconomy, and thus for credit quality, remains uncertain," hesaid.
"Helping the financial markets to return to more normalfunctioning will continue to be a top priority of the FederalReserve," he added.
(Additional reporting by David Lawder, Lisa Lambert, JoanneMorrison and Pedro Nicolaci da Costa in Washington; Editing byChizu Nomiyama)
