Bernanke: Focus still on inflation

NEW YORK (CNNMoney.com) -- The Federal Reserve has not shifted away from fighting inflation but is looking for more room to maneuver in an environment of heightened risk, posed in part by risky mortgage loans, Chairman Ben Bernanke said Wednesday.

"We are looking for a bit more flexibility given the uncertainties that we are facing and the risks that are occurring on both sides of our outlook," Bernanke testified before the Joint Economic Committee of Congress.

Bernanke's comments came in response to questions seeking clarification of Fed policy. The central bank threw markets into confusion last week after it left a phrase out of its policy statement that had been in several of its earlier statements.

In the statement after its meeting last Wednesday, the Fed did not say that "additional firming" of interest rates may be needed to address the risk of inflation.

The omission of the phrase led many investors to believe the central bank was softening its stance on future rate hikes - and might even start cutting rates later this year. Those bets fueled a big stock market rally, pushing the Dow up about 160 points.

The market has since fallen back on signs of weakening economic growth.

The Fed, which is responsible for controlling inflation but also keeping down unemployment, faces risks on both fronts. The economy has been slowing, due mainly to cooling in the housing sector. That has raised concerns that unemployment will rise. At the same time, inflation is running ahead of the Fed's comfort zone.

In Wednesday's testimony, Bernanke emphasized that the Fed remains committed to fighting inflation. "Our policy is still oriented toward control of inflation which we consider at this time to be the greater risk," he said.

He also reiterated his expectations for the economy to keep growing at a moderate pace, noting that consumer spending remains solid.

But he also underscored the downside risk posed by the slowdown in the housing market. Growing problems in the subprime lending sector could lead to a more severe correction in housing, he said. So far, those problems don't appear to be spreading to the rest of the mortgage market, he added.

A jump in defaults on subprime mortgages - loans to home owners with weak credit - has sparked worries the housing slump may drag on and is already curtailing credit as mortgage lenders tighten lending standards. Bernanke referred to that risk in his remarks to lawmakers.

He also voiced concerns about a slowdown in business spending. "Although some of this pullback can be explained by the recent moderation in the growth of output, the magnitude of the slowdown has been somewhat greater than would be expected given the normal evolution of the business cycle," he said.

Some economists had hoped that strong business spending would help the economy through the housing downturn, but a soft reading on durable goods orders on Monday dashed those hopes. (Full story)

At their meeting last week, Fed policymakers kept the target for the Fed's key short-term interest rate steady at 5.25 percent. The central bank has left interest rates unchanged at its last six meetings.

Decline in business spending raise alarms

Test your Fed IQ