Federal Reserve Chairman Ben Bernanke warned on Wednesday the US economy still faced a risk of heightened inflation but said cooler growth should curb price pressures over time.
In remarks that were seen as keeping the US central bank's options open on interest rates, Bernanke said the Fed faced both the risk of pushing rates too high and damaging the economy, and the danger of not doing enough to curb inflation.
"There are risks in both directions, if I may say so," he told the Senate Banking Committee as he delivered the Fed's semi-annual report on monetary policy.
An unexpectedly steep 0.3 percent climb in June core consumer prices reported earlier on Wednesday led financial markets to bet heavily on an 18th increase at the Fed's next meeting on August 8.
Traders, however, trimmed those bets on Bernanke's testimony. US stocks logged their biggest one-day percentage gain in three weeks, while prices for US government bonds, down earlier, turned up. The dollar fell.
Bernanke, who will address a House of Representatives panel on Thursday, said the Fed was concerned about recent elevated inflation readings and warned that if inflation did gain a foothold, it would be "costly" to reverse.
But he also said the full economic impact of 17 prior interest-rate increases had yet to be felt and that the Fed must be forward-looking in all its decisions.
"We must consider not only what appears to be the most likely (economic) outcome, but also the risks to that outlook and the costs that would be incurred should any of those risks be realised," Bernanke said.
The Fed has raised benchmark overnight interest rates to 5.25 percent in a string of small steps dating to June 2004. Analysts said the testimony offered something for both inflation hawks and doves.
Referring to former Fed chief Alan Greenspan, Stephen Stanley, chief economist at RBS Greenwich Capital said: "Unlike his predecessor, Bernanke's rhetoric is clear. We know what he saying, it's just very noncommittal."
"The Federal Reserve must guard against the emergence of an inflationary psychology that could impart greater persistence to what would otherwise be a transitory increase in inflation," Bernanke said. "Persistently higher inflation would erode the performance of the real economy and would be costly to reverse," he added.
Still, Bernanke said the economy, which shot ahead at a 5.6 percent annual rate in the first quarter, appeared to be "in a period of transition" to more-moderate growth.
He said consumer spending had slowed, partly because of a waning housing market, although other sectors of the economy, including business investment, were growing solidly. Bernanke also said global growth was strong enough to boost demand for US exports. However, this had also sparked increased competition for oil and other basic commodities that was helping drive up prices.
Fed officials now expect core inflation - as measured by their favoured price index - to be between 2.25 percent and 2.5 percent this year, edging down to 2 percent to 2.25 percent in 2007. In February, they had expected core prices to rise about 2 percent in 2006, and 1.75 percent to 2 percent next year.
Bernanke noted that gauges of long-term inflation expectations had edged down after rising earlier this year, but said the Fed was closely monitoring the situation. He noted that futures markets expect oil prices to stabilise and said this could ease inflation pressures.