New Fed chief Bernanke warns on inflation

By Tim Ahmann

WASHINGTON (Reuters) – In his Capitol Hill debut as Federal
Reserve chief, Ben Bernanke on Wednesday said the U.S. economy
was running so near capacity that higher interest rates may be
needed to quell the risk of inflation.

The Fed chairman appeared keen to establish credentials as
an inflation “hawk” in his first extensive comments since
taking office two weeks ago by stressing the need to keep price
pressures contained.

“The risk exists that, with aggregate demand exhibiting
considerable momentum, output could overshoot its sustainable
path, leading ultimately — in the absence of countervailing
monetary policy action — to further upward pressure on
inflation,” Bernanke told the U.S. House of Representatives
Financial Services Committee.

Bernanke’s testimony on the Fed’s semiannual report to
Congress on monetary policy pushed prices for U.S. government
bonds down and lifted the dollar as investors braced for more
rate hikes. Stock prices were flat.

“He is achieving what I consider to be his key objective in
this testimony, which was to keep the market expecting higher
rates,” said economist Eric Green at Countrywide Financial in
Calabasas, California.

The central bank has raised benchmark overnight rates to
4.5 percent in 14 steps and markets expect the Bernanke-led Fed
to lift credit costs at its next meeting on March 27-28, with a
good chance they will reach 5 percent by mid-year.

Bernanke, who appears before a Senate panel on Thursday,
seemed comfortable and in command as he endured 2-3/4 hours of
often pointed questioning.

He offered thoughts on topics ranging from wage inequality
to terrorism insurance to the potential dangers mortgage market
giants Fannie Mae and Freddie Mac pose to the U.S. financial
system.

But he adhered to a pledge he made in November to avoid
being drawn into budget debates.

“I just don’t want to be injecting myself into the
specifics of how to do that,” he said, sidestepping one of
repeated questions on how to cut the hefty U.S. budget gap.

ECONOMY ON TRACK

Bernanke said recent data, including a report on Tuesday
that showed retail sales boomed in January, “suggests that the
economic expansion remains on track” after a strong 2005.

But he warned that high energy prices and tightening
economic conditions could push prices higher.

“The economy now appears to be operating at a relatively
high level of resource utilization,” Bernanke said, alluding to
tight labor markets and diminishing slack at industrial firms.

The Fed on Wednesday said the amount of industrial capacity
in use fell to 80.9 percent in January on a drop in utility
output amid warm weather. But December’s figure was revised
higher and factory capacity use hit its highest level since
July 2000.

Bernanke noted the Fed’s policy-setting Federal Open Market
Committee said on January 31 that further policy firming may be
needed, adding this was “an assessment with which I concur.”

But the new Fed chief, who took over from Alan Greenspan on
February 1, also said the central bank had made “substantial
progress” in raising interest rates to a more normal level.

“As a consequence, in coming quarters the FOMC will have to
make ongoing, provisional judgments about the risks to both
inflation and growth, and monetary policy actions will be
increasingly dependent on incoming data,” Bernanke said.

EYE ON HOUSING

While he underscored inflation risks, Bernanke also said
high energy costs could weigh on growth and a possible slowdown
in the housing market bore close watching.

Fed officials expect the economy to grow about 3.5 percent
this year, about the same as in 2005, and 3 percent to 3.5
percent in 2007.

The jobless rate was expected to come in between 4.75
percent and 5 percent at the end of this year and next. The
jobless rate fell to a 4-1/2 year low of 4.7 percent in
January, but that data came after officials assembled their
forecasts.

Core inflation was seen at 2 percent this year, just a
touch ahead of 2005, and 1.75 percent to 2 percent in 2007.

Bernanke played down fears a housing slowdown could derail
the economy and expressed confidence that demand from elsewhere
would “pick up the slack.”

“A leveling out or a modest softening of housing activity
seems more likely than a sharp contraction, although
significant uncertainty attends the outlook,” he said.

He said a yield curve inversion in the U.S. bond market,
where short-term rates are higher than long-term rates, did not
signal an economic slowdown, as they have often in the past.

(Additional reporting by Glenn Somerville, Andrea Hopkins,
Alister Bull, Mike Dolan, Kristin Roberts)