"It is important to assure the public and the markets that the extraordinary policy measures we have taken in response to the financial crisis and the recession can be withdrawn in a smooth and timely manner as needed, thereby avoiding the risk that policy stimulus could lead to a future rise in inflation," Bernanke said. "We are confident that we have the necessary tools to implement that strategy when appropriate."
To revive the economy, the Fed has plowed trillions into the financial system in an effort to drive down rates on mortgages and other consumer debt. It also has created programs to bust through credit clogs, a key ingredient to turning the economy around.
When the time comes, the Fed will need to soak up that money.
Besides raising its key bank lending rate, the Fed can raise the rate it pays banks on reserve balances held at the central bank, Bernanke said. That would give banks an incentive to keep their money parked there, rather having it flow back into the financial system, where it can stoke inflationary pressures. The Fed also can drain money from the financial system by selling securities from its portfolio with an agreement to buy them back at a later date or it can sell securities outright.
Steering the economy from recession to recovery will be a delicate move for Bernanke — economically and politically.
On the economic front, Bernanke repeated the Fed's forecast that the economy should start growing again in the second half of this year, but he warned growth would be slight, leading to higher unemployment.
Despite some improvements — including a stabilization in consumer spending and moderating declines in housing activity — the economy remains vulnerable, he said.
"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."
The nation's unemployment rate climbed to a 26-year high of 9.5% in June. The Fed says it could rise as high as 10.1% this year, and stay elevated into 2011. The post-World War II high was 10.8% at the end of 1982, when the country had suffered through a severe recession.
Expectations for a lethargic recovery should keep a lid on inflation this year, Bernanke said. With consumers likely to stay cautious amid rising unemployment, companies won't be able to jack up prices.