By Pedro da Costa and Alister Bull
WASHINGTON (Reuters) - The Federal Reserve's monetary stimulus is helping the U.S. economy recover but the U.S. central bank needs to see further signs of traction before taking its foot off the gas, Fed Chairman Ben Bernanke said on Wednesday.
In testimony that offered little sign he is ready to retreat from the Fed's latest round of bond buying, Bernanke emphasized the high costs of unemployment and inflation that continues to run below the Fed's target.
"Monetary policy is providing significant benefits," he told the congressional Joint Economic Committee, citing strong consumer spending on autos and housing, as well as increases in household wealth.
"Monetary policy has also helped offset incipient deflationary pressures and kept inflation from falling even further below the (Fed's) 2 percent longer-run objective."
Still, he said in answer to a question, the central bank could decide to scale back the $85 billion in bonds it is buying each month at one of its "next few meetings" if the economic recovery looked set to maintain forward momentum.
That remark cut into gains in U.S. stock markets <.SPX> and killed a bond market rally that had been fueled by Bernanke's earlier remarks and comments from the head of the New York Federal Reserve Bank, who suggested the Fed would not consider trimming purchases for several months.
The central bank is currently buying $45 billion in Treasury bonds and $40 billion in mortgage-backed debt each month to keep borrowing costs low and encourage investment, hiring and economic growth. It is the third round of asset purchases, or quantitative easing, since the Fed drove interest rates to near zero in late 2008.
"I believe the Fed, while feeling more confident in the economy bottoming, is not yet comfortable with ending QE and the U.S. economic crutch it offers," said Douglas Borthwick, managing director of Chapdelaine Foreign Exchange in New York.
MISSING THE TARGET
Bernanke noted that the main inflation gauge the Fed monitors rose just 1 percent in the 12 months through March, just half the central bank's 2 percent target.
Part of the reason, he said, was a decline in energy prices. But there were also indications of more broad-based disinflation, Bernanke said.
He said the Fed was prepared to either increase or reduce the pace of its bond buys depending on economic conditions, as the central bank stated on May 1 after its last policy meeting.
"If we see continued improvement and we have confidence that that's going to be sustained then we could in the next few meetings ... take a step down in our pace of purchases," he said.
"If we do that it would not mean that we are automatically aiming towards a complete wind down. Rather, we would be looking beyond that to see how the economy evolves and we could either raise or lower our pace of purchases going forward."
U.S. economic growth rose to a 2.5 percent annual rate in the first quarter following an anemic end to 2012. The unemployment rate has fallen to 7.5 percent from a peak of 10 percent, but remains, as Bernanke put it, "well above its longer-run normal level."
Recent economic data have been mixed. Job growth, retail sales and housing have all shown some vigor, but factory output has been contracting.
Bernanke said some headwinds facing the economy, including the debt crisis in Europe, have been dissipating. But he said a sharp tightening of the U.S. government's budget had become too big of a drag on growth for the central bank to fully offset.
He told the committee the Fed was aware of the risk that keeping monetary policy too easy for too long could fuel asset price bubbles. However, he said the central bank believed major assets prices were justified by the economy's fundamentals.
Further, he warned of the risks to pulling back on stimulus too early.
"A premature tightening of monetary policy could lead interest rates to rise temporarily but would also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further," Bernanke said.
TOO SOON TO TAPER
In separate remarks, New York Fed President William Dudley stressed that uncertain economic conditions meant it was too early to determine whether to taper the Fed's bond purchases.
"It's too soon to make that determination," Dudley said in a Bloomberg TV interview that took place Tuesday but aired Wednesday. "I think three or four months from now you'll have a much better sense of is the economy healthy enough to overcome the fiscal drag or not."
Dudley added it was possible to dial down the quantitative easing program by the fall "if the economy does better and if the labor market continues to improve" in the face of lower government spending and higher taxes.
Asked whether the Fed would curtail the pace of its bond purchases by the September 2 Labor Day holiday, Bernanke said simply: "I don't know."
The release at 2 p.m. (1800 GMT) of minutes of the last Fed policy meeting will shed light on how much debate there was about a possible curtailing of asset buys.
The Fed next meets on June 18-19.
(Additional reporting by Jonathan Spicer and Steven C. Johnson in New York; Editing by Tim Ahmann and Andrea Ricci)
