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RISMEDIA, Feb. 15, 2007-(WSJ.com)-Federal Reserve Chairman Ben Bernanke signaled Wednesday that he's comfortable with current interest rate levels but stands ready to resume rate increases if inflation doesn't moderate as the Fed expects.

"So far, the incoming data have supported the view that the current stance of policy is likely to foster sustainable economic growth and a gradual ebbing of core inflation," Bernanke said in prepared testimony to the Senate Banking Committee.

However, Bernanke said twice in his prepared remarks that the Fed's "predominant" concern is that inflation won't come down as expected, and cautioned that the central bank is "prepared to take action to address inflation risks if developments warrant."

The Fed has kept interest rates steady at 5.25% since last summer, a stretch covering five Federal Open Market Committee meetings, and is widely expected to keep them steady at least through the middle of this year.

'Noisy' Monthly Data

While inflationary pressures "are beginning to diminish," Bernanke cautioned that monthly data are "noisy" and it will "be some time before we can be confident that underlying inflation is moderating as anticipated."

In a policy statement last month, officials were upbeat on both growth and inflation. Still, they warned "some inflation risks remain" and kept their tightening bias, suggesting that rate cuts aren't on their radar screen, a message reinforced by Bernanke Wednesday.

The U.S. economy expanded at a 3.5% clip in the fourth quarter, above what's considered the economy's noninflationary potential of around 3%, but recent trade and inventory data suggest that figure will be revised to below 3%.

Bernanke said the U.S. should post "moderate" economic growth this year and next. According to the Fed's forecasts, also released Wednesday, gross domestic product should expand between 2.5% and 3% this year and 2.75% to 3% in 2008.

But Bernanke cautioned that "the risks to this outlook are significant." The housing sector remains a downside risk, he said, despite "tentative" signs of stabilization. He explained that even if housing demand stabilizes, it will continue to weigh on growth as homebuilders reduce their inventories of unsold homes.

On the other hand, consumer spending, which was "brisk" in the second half of 2006, is an upside risk to growth, Bernanke said. Household finances remain in good shape, he said, though delinquency rates for subprime mortgages with variable rates "have increased appreciably."

The business sector, meanwhile, is in "excellent" financial shape, Bernanke said, and capital spending should grow at a "moderate pace."

Inflation Concerns

As for inflation, Bernanke said the "waning" of temporary factors like energy prices and rents "will probably help foster a continued edging down of core inflation." Productivity trends, meanwhile, "appear favorable," he said.

But risks remain to that scenario, he cautioned. While moderate growth should ease pressure on labor and product markets, the current high level of resource utilization "remains an important upside risk to continued progress on inflation," Bernanke said. He also noted that labor compensation has shown signs of acceleration, in part due to the tight jobs market.

The Fed is widely understood to have a comfort zone of 1% to 2% for annual growth in the personal consumption expenditures price index excluding food and energy. That index, through December, was 2.2%, down from a 2006 peak of 2.5% in August.

The Fed expects core inflation to remain above that range at 2% to 2.25% this year and then, according to Bernanke, "edge lower" to between 1.75% and 2% in 2008. That forecast suggests officials won't be comfortable with core inflation simply hitting the top end of its comfort zone and that they'd like to see it come under 2%.

Bernanke called it "encouraging" that inflation expectations "appear to have remain contained."

Monetary Policy Report

"Increases in core consumer prices are expected to moderate, on balance, over the next two years," the Fed said in its semi-annual monetary policy report to Congress. "Along with inflation expectations that are well anchored, some of the factors that boosted inflation in recent years seem likely to lessen."

The central bank cited falling energy and commodity prices as likely contributors to reduced price pressures. "The paths for prices of energy and other commodities embedded in futures markets suggest that the impetus to core inflation from these influences will diminish further," the Fed said.

"In addition, the outsized increases in shelter costs that boosted core inflation last year are not expected to persist," the Fed said. And while unit labor costs have been rising, the Fed said the "average markup of prices over such costs is high by historical standards."

"That relatively high markup suggests further increases in costs could be absorbed, at least to some extent, by a narrowing of firms' profit margins rather than by passing on the costs in the form of higher consumer prices," the Fed added.

Still, the Fed said there was uncertainty around expectations for a moderation in price pressures, and the central bank reiterated its concern that the long-term risks are that inflation will fail to moderate as expected.

"On the one hand, the nation's potential to produce could increase more rapidly than anticipated, or product and input markets could work efficiently at higher rates of utilization," which the Fed said would help restrain inflation more than forecast.

But rising global demand for energy and commodities could push those costs higher, while persistently elevated cost levels could hurt inflation expectations. "If inflation were to persist around the elevated average level of the past three years, longer-run inflation expectations could deteriorate, particularly if pressures on resources were to intensify," the Fed said.

"At recent meetings, [The Federal Open Market Committee] indicated that the risk that inflation will fail to moderate as expected is its predominant policy concern," the Fed forecast said.

Growth Expectations

The Fed also predicted the U.S. economy will grow 2.5%-3.0% in 2007, after projecting five months ago that growth would be between 3.0%-3.25% this year. For 2008, the Fed forecast the economy will expand 2.75%-3.0%.

"On balance, growth of real domestic product in the United States appears likely to run slightly below that of the economy's potential over the next few quarters and then to rise to a pace around that of the economy's long-run trend," the Fed said.

But the Fed forecasts — which compare projected fourth quarter data against fourth quarter data of the previous year — did not appear to stress that moderating economic growth will help restrain inflation going forward.

"The economic outlook for this year and next appears favorable," the Fed said, as the slowdown in the housing market is expected to diminish this year, while gains in real wages, along with employment gains, "should support a solid rise in consumer spending."

The outlook for economic strength in the business sector was likewise favorable, the Fed said. Strong business balance sheets, along with "further expansion in business output, user costs of capital equipment that remain attractive, and the potential for further gains in efficiency, should continue to spur business investment," the Fed said.

Still, the Fed said the outlook for growth was uncertain, with upside risks that consumer spending "may continue to expand at a pace that would ultimately lead to an escalation of pressure on resources and prices."

On the flip side, "if home values were to depreciate sharply, the resulting erosion of household wealth could impose appreciable restraint on consumer spending."

The Fed also projected the unemployment rate to remain relatively steady, at 4.5%-4.75% this year and next, compared to the current 4.6% current level.

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