July 21 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke said while the economy is showing “tentative signs of stabilization,” the central bank intends to maintain a “highly accommodative” monetary policy for “an extended period.”

“The pace of decline appears to have slowed significantly,” Bernanke said today in semi-annual testimony before the House Financial Services Committee. At the same time, “in light of the substantial economic slack and limited inflation pressures, monetary policy remains focused on fostering economic recovery,” he said.

Fed officials said in a report submitted as part of Bernanke’s testimony that policy will be “tightened” when the labor market improves, an economic recovery takes hold and pressures holding down inflation “diminish.” The comments follow a rally in stocks and a rebound in corporate earnings that have stoked speculation the worst recession in half a century is ending.

Bernanke, 55, defended the central bank’s actions to restore financial stability, urged lawmakers to lay plans for reining in the deficit, and warned Congress against impinging on the Fed’s independence in his testimony. Bernanke, responding to a question, said the Obama administration’s plan to make the Fed a systemic-risk regulator would be a “modest reorientation” of its authority, and he argued against the plan’s proposal to strip the Fed of consumer-protection role.

Unprecedented Actions

The Fed chief has countered the credit crisis with actions unprecedented in the central bank’s 95-year history, cutting the benchmark lending rate to as low as zero and flooding the banking system with cash. He today detailed how the Fed can reverse the stimulus “when appropriate,” and expressed confidence it has tools to prevent any inflation surge.

Bonds rose and stocks reversed gains after Bernanke’s statement was released. The yield on the benchmark 10-year Treasury note fell to 3.46 percent at 11:56 a.m. in New York, from 3.61 percent late yesterday. The Standard & Poor’s 500 Index was down 0.4 percent at 946.94.

Some companies are beating analysts’ earnings estimates. Coca-Cola Co. reported adjusted second-quarter profit of 92 cents a share. Analysts surveyed by Bloomberg estimated 89 cents. Caterpillar Inc., the biggest maker of earth-moving equipment, said 2009 earnings before some items will be $1.15 to $2.25 a share. Analysts surveyed by Bloomberg had expected $1.12 on average.

Markets ‘Stressed’

Bernanke said dangers remain, and didn’t indicate that a sustained recovery has yet taken hold. He said that financial markets remain “stressed,” and household spending is an “important” risk to the outlook because of continued job losses and declines in home values.

He also said that record budget deficits may begin to pose a threat to the recovery.

“Unless we demonstrate a strong commitment to fiscal sustainability, we risk having neither financial stability nor durable economic growth,” Bernanke said.

The Fed has expanded credit to the economy by $1.1 trillion over the past year. Bernanke is leading plans to buy as much as $1.25 trillion of mortgage-backed securities and $200 billion of federal agency debt by year end, and $300 billion of long-term Treasuries by September. In June, the Federal Open Market Committee pledged to keep rates “exceptionally low” for an “extended period,” and left the benchmark lending rate in a range of zero to 0.25 percent.

Bernanke didn’t go beyond the FOMC’s statement in his outlook on rates, and instead spent more time on the central bank’s exit strategy.

Rate Strategy

“We have a number of tools that will enable us to raise market interest rates as needed,” he said, noting that outright sales from the Fed’s portfolio would also raise longer-term interest rates. He previewed the discussion in an opinion piece published late yesterday in the Wall Street Journal.

Among the five options, the interest rate on banks’ deposits with the Fed is “perhaps the most important” tool, Bernanke said. It “will most likely be used in combination” with other methods, including reverse-repurchase agreements and term deposits, the report said.

Other options include for the Treasury to sell bills and deposit the funds with the Fed, and to sell some of the long- term securities on the Fed’s balance sheet, Fed officials said in the accompanying Monetary Policy Report.

Assets on the Fed’s balance sheet “may remain very large for some time,” the Fed report said. “Without additional actions, the level of bank reserves would continue to remain elevated as well.”

Winding Down Stimulus

Fed officials are trying to assure markets they can wind down the monetary stimulus rapidly if needed to avoid inflation. They must also avoid stalling an expansion with a premature rate increase.

“The main risks remain on the downside,” J. Alfred Broaddus Jr., the former president of the Richmond Fed, said before the announcement. “With the kind of weakness we are seeing in the economy, you’ve got to be very careful about taking monetary stimulus away.”

The Fed chairman comes to Capitol Hill after the bursting of the housing bubble toppled some of the nation’s biggest financial institutions. In September, Lehman Brothers Holdings Inc. filed for bankruptcy, and Merrill Lynch & Co. agreed to be acquired by Bank of America Corp.

Bernanke has said emergency lending for Bear Stearns Cos. And insurer American International Group Inc. were necessary to prevent a collapse of the financial system and the economy. Today he again defended the Fed’s response.

‘Aggressive Policy’

“Aggressive policy actions taken around the world last fall may well have averted the collapse of the global financial system,” he said. “Many of the improvements in financial conditions can be traced, in part, to policy actions taken by the Federal Reserve.”

Bernanke told members of Congress that the Fed’s emergency lending authority “ought to be subordinated” to a resolution agency that would use those loans for an “orderly winddown” of troubled financial firms.

Interbank lending rates have fallen, he noted, and mortgage refinancing has increased with support from Fed backstops. The cost of three-month dollar loans in London, or the London interbank offered rate, or Libor, stood at 0.51 percent Monday, down from 1.42 percent at the start of the year.

A rising stock market and lower funding costs have boosted the earnings of financial firms. Goldman Sachs Group Inc. posted record earnings as revenue from trading and stock underwriting reached all-time highs less than a year after the firm took $10 billion in U.S. rescue funds.

Danger of Losses

Still, the Fed said in its report today that “many financial institutions” face the danger of “significant additional losses.”

Members of Congress have questioned the Fed’s use of extraordinary powers, and the central bank may face one of the biggest revisions of its regulatory authorities and mandates since the Great Depression.

The Fed chairman today made a case for keeping the central bank’s consumer protection authority, and he warned against an expansion of the Government Accountability Office’s audit authority over the Fed, a proposal supported by some members of Congress.

“A perceived loss of monetary policy independence could raise fears about future inflation, leading to higher long-term interest rates and reduced economic and financial stability,” he said. The Fed has been “doing a good job” on consumer protection for the past three years, he said in response to a question.

Praise From Obama

Bernanke’s term as chairman expires in January. President Barack Obama said last month that Bernanke has done “a fine job” as Fed Chairman while declining to comment on his possible reappointment, which is subject to Senate approval.

The economy shrank at a 5.5 percent annual rate in the first quarter, following a 6.3 percent annual rate of decline in the final three months of last year, the worst back-to-back quarterly performance in a half century. Companies slashed inventories at an $87.1 billion annual pace in the first three months, the biggest drop on record.

Unemployment has continued to rise even as the economy shows signs of mending. The jobless rate in June rose to 9.5 percent, the highest in almost 26 years.

The Monetary Policy report noted that “at some point,” an economic recovery “will take hold, labor market conditions will improve, and the downward pressures on inflation will diminish.” It added that “When this process has advanced sufficiently, the stance of policy will need to be tightened” to keep inflation at bay.

Growth Forecasts

Policy makers are divided over how fast the economy will grow, their June forecasts show. The gap between the fastest and slowest estimated growth rate for next year was 3.2 percentage points, up from a 2.5 percentage-point divide in April. The lowest forecast suggests the economy will grow just 0.8 percent from this year’s fourth quarter to the final quarter of 2010; the highest projects 4 percent growth.

The forecasts were previously released in the minutes of the June Federal Open Market Committee meeting.

The pace of recovery is critical to a sustained expansion, economists said. One risk is that the economy grows several quarters below a rate needed to absorb a growing labor force. That would result in even higher unemployment and possibly weaker income growth, stalling demand and cutting the inventory cycle short.

“Job insecurity, together with declines in home values and tight credit, is likely to limit gains in consumer spending,” Bernanke said. “The possibility that the recent stabilization in household spending will prove transient is an important downside risk to the outlook.”

To contact the reporters on this story: Craig Torres in Washington at ctorres3@bloomberg.net.

Last Updated: July 21, 2009 11:59 EDT