(RTTNews) - Federal Reserve Chairman Ben Bernanke offered a bleak economic outlook to Congress Tuesday, saying that downside risks to economic growth have increased while at the same time the upside risks to inflation have intensified since he last testified in February.

“The possibility of higher energy prices, tighter credit conditions, and a still-deeper contraction in housing markets all represent significant downside risks to the outlook for growth,” the Fed Chairman said in prepared remarks before the Senate Banking Committee.

“At the same time, upside risks to the inflation outlook have intensified lately, as the rising prices of energy and some other commodities have led to a sharp pickup in inflation and some measures of inflation expectations have moved higher,” he added.

Bernanke spoke as part of the Federal Reserve’s semi-annual Monetary Policy Report to the Congress, noting that the U.S. economy and financial markets have confronted some “significant challenges thus far in 2008.”

The continued collapse of the housing market combined with “financial headwinds” on consumer spending as soaring energy and commodity prices weigh heavily on the U.S. consumer has led economic activity to advance at a “sluggish pace” during the first six months of 2008, Bernanke said, while inflation has “remained elevated.”

“The economy continues to face numerous difficulties, including ongoing strains in financial markets, declining house prices, a softening labor market, and rising prices of oil, food, and some other commodities,” Bernanke said.

The financial markets have faced what some including Federal Reserve Governor Frederic Mishkin have labeled the worst crisis since the Great Depression. Bernanke recognized the primary role well-functioning markets play in healthy economic growth.

“Consequently, helping the financial markets to return to more normal functioning will continue to be a top priority of the Federal Reserve,” he said, attempting to soothe the markets.

Bernanke noted that the “subdued” economic growth in the first half of 2008 will likely continue, and the pace is expected to pick up gradually over the next two hears. He noted that there is “considerably uncertainty” to this FOMC forecast, and risks are viewed as “skewed to the downside.”

Throughout the remainder of 2008 the FOMC expects growth at a pace “appreciably below its trend rate,” Bernanke said, citing the now-familiar trio of headwinds facing the economy of a slumping housing market, record energy prices, and continued turmoil in the credit markets.

Inflation “has remained high,” the Fed Chairman said, and with $4 gasoline and other consumer energy prices rising he predicts no immediate relief.

“Inflation seems likely to move temporarily higher in the near term,” Bernanke said.

Although FOMC members still expect inflation to moderate into 2009 and 2010, that forecast has been viewed as “unusually uncertain” and participants “cited the possibility that commodity prices will continue to rise as an important risk to the inflation forecast,” Bernanke said.

“Moreover, the currently high level of inflation, if sustained, might lead the public to revise up its expectations for longer-term inflation,” he warned, cautioning that a wage-price spiral could then occur as employers are forced to boost wages for struggling employees.

“If that were to occur, and those revised expectations were to become embedded in the domestic wage- and price-setting process, we could see an unwelcome rise in actual inflation over the longer term,” Bernanke added. “A critical responsibility of monetary policy makers is to prevent that process from taking hold.”

The unprecedented rise in the price of crude oil that has ratcheted up inflationary pressure is largely due to tight supply conditions, Bernanke said, dismissing speculation as a major factor in the recent run-up in fuel prices. The Fed Chairman suggested no relief from elevated oil prices.
“Long-dated oil futures prices have risen along with spot prices, suggesting that market participants also see oil supply conditions remaining tight for years to come,” he said.

The Fed Chairman also addressed the decline in the dollar, noting that “the decline in the foreign exchange value of the dollar has also contributed somewhat to the increase in oil prices,” although he maintained that shifts in demand for and supply of oil are the “principal drivers” of the price increase.

These competing factors have presented a “significant challenge” for policymakers, Bernanke said, and FOMC participants will need to continue their careful assessment for any impact it might have on inflation and growth expectations.

“In light of the increase in upside inflation risk, we must be particularly alert to any indications, such as an erosion of longer-term inflation expectations, that the inflationary impulses from commodity prices are becoming embedded in the domestic wage- and price-setting process,” he said.

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