By Pedro da Costa and Alister Bull
WASHINGTON, Feb 26 (Reuters) - Federal Reserve Chairman Ben Bernanke strongly defended the U.S. central bank's bond-buying stimulus before Congress on Tuesday, saying its benefits clearly exceed possible costs.
The Fed chairman also urged lawmakers to avoid sharp spending cuts set to go into effect on Friday, which he warned could combine with earlier tax increases to create a "significant headwind" for the economic recovery.
Bernanke said Fed policymakers are cognizant of potential risks from their extraordinary support for the economy, including the possibility the public loses confidence in the central bank's ability to unwind its stimulus smoothly or the potentially destabilizing effect of low rates on key markets.
But he added these did not seem material at the moment, adding the central bank has all the tools it needs to retreat from its monetary support in a timely fashion.
"To this point, we do not see the potential costs of the increased risk-taking in some financial markets as outweighing the benefits of promoting a stronger economic recovery and more rapid job creation," Bernanke said in remarks prepared for delivery to the Senate Banking Committee.
Minutes of the Fed's Jan. 29-30 policy meeting, released last week, showed that a number of officials felt the potential risks posed by buying bonds could warrant tapering or ending the program before hiring picks up. However, several others argued there was a danger in halting it prematurely.
Bernanke appeared to be in the latter camp, citing improvements in the housing and auto sectors and tracing them in part to the Fed's stimulus.
He also noted that inflation, one of the risks most often cited by critics of the central bank's so-called quantitative easing, remains projected to stay at or below the Fed's 2 percent target for the foreseeable future.
In response to the financial crisis and deep recession of 2007-2009, the Fed not only slashed official interest rates to effectively zero but also bought more than $2.5 trillion in mortgage and Treasury debt in an effort to push down long-term interest rates and spur investment.
The Fed is currently buying $85 billion in bonds each month and has said it plans to keep purchasing assets until it sees a substantial improvement in the outlook for the labor market.
In unusually direct remarks on fiscal policy, Bernanke warned that the near-term spending cuts know as the sequester, which are set to take hold later this week, threaten an already challenged economic expansion.
"The Congress and the administration should consider replacing the sharp, frontloaded spending cuts required by the sequestration, with policies that reduce the federal deficit more gradually in the near term but more substantially in the longer run," Bernanke said.
"A substantial portion of the recent progress in lowering the deficit has been concentrated in near-term budget changes, which, taken together, could create a significant headwind for the economic recovery," he said.
The U.S. economy braked sharply in the fourth quarter, but is generally forecast to grow around 2 percent or more this year. Unemployment has remained elevated, and registered 7.9 percent in January.
Bernanke said persistent joblessness was a scourge with potentially long-lasting effects for the United States.
"High unemployment has substantial costs, including not only the hardship faced by the unemployed and their families, but also the harm done to the vitality and productive potential of our economy as a whole," Bernanke said.