Federal Reserve Chairman Ben Bernanke on Monday said the U.S. economy's recovery remained fragile and unemployment may be high for some time, cooling anticipation of an early increase in U.S. interest rates.

Three days after news of a surprise fall in the jobless rate prompted investors to speculate the Fed might move more quickly to raise rates than had been expected, Bernanke said the Fed -- the U.S. central bank -- was sticking to its pledge to hold benchmark borrowing costs at exceptionally low levels for an extended period.

We still have some ways to go before we can be assured that the recovery will be self-sustaining, he told the Economic Club of Washington. Also at issue is whether the recovery will create the large number of jobs that will be needed to materially bring down the unemployment rate.

A report on Friday showed the U.S. labor market last month turned in its best performance since the economy fell into recession two years ago as the unemployment rate receded slightly from a 26-1/2-year high and job losses slowed sharply.

The data led investors to ramp up bets benchmark U.S. rates would rise by the middle of next year, lifting the dollar to its biggest gain in nearly a year.

However, Bernanke on Monday suggested the Fed's policy-setting Federal Open Market Committee (FOMC), which meets next week to debate policy, would bide its time to let the recovery gather strength. His comments drove the dollar and prices for U.S. government bonds lower, while offering temporary support to stocks.

Right now we are still looking at the extended period given that conditions remain -- low rates of (resource) utilization, subdued inflation trends, and stable long term inflation expectations, he said. That remains where we are.

This view was echoed by another top Fed official, New York Federal Reserve Bank President William Dudley, speaking at Columbia University in New York on Monday evening.

The recession now appears to be over, but the economy is still weak and the unemployment rate is much too high, Dudley said.

These circumstances underpin the FOMC's commitment to keeping short-term rates exceptionally low for an extended period.

FORMIDABLE HEADWINDS

Bernanke said tight credit and the weak job market still posed formidable headwinds to recovery, but he said officials would need to consider recent signs that the economy was gaining strength at their meeting on Tuesday and Wednesday.

The Fed cut rates to near zero a year ago and has pumped more than $1 trillion into the economy to battle a deep recession. Now, analysts are beginning to wonder when it will begin to remove its extraordinary support.

Financial markets will parse the Fed's policy statement next week closely for any fresh clues, but Bernanke suggested the central bank remains focused on nurturing the recovery.

He's being appropriately cautious about the outlook, said Mark Zandi, chief economist at Moody's Economy.com in West Chester, Pennsylvania. The economy is not going to come roaring back.

While underscoring the recovery's fragility, both Bernanke and Dudley took pains to argue that worries the Fed's easy money policies are setting the stage for runaway inflation later are unfounded.

Will the Federal Reserve's actions to combat the crisis lead to higher inflation down the road? Bernanke asked. The answer is no. The Federal Reserve is committed to keeping inflation low and will be able to do so.

Bernanke said that although the Fed will continue to monitor inflation closely, it appears likely to remain subdued for some time and could in fact move lower.

FED HAS EXIT TOOLS

The challenge the Fed faces in withdrawing its massive support for the economy is not how to do it but when, he said.

The central bank has all the tools it needs, and could raise rates even if its balance sheet -- swollen by purchases of mortgage-related debt and longer-term Treasury securities -- remains large, Bernanke added.

He said the Fed's ability to pay interest on the reserves banks hold at the Fed would be an important tool to push borrowing costs higher, and said there were a number of ways it could withdraw money from the financial system.

If necessary, we always have the option of reducing the size of our balance sheet by selling some of our securities, he said.

The New York Fed's Dudley also emphasized that while the exit from easy monetary policy will be more complicated than usual due to the array of stimulus the Fed has put in place, he believes the process is manageable.

The fact we have more levers doesn't mean we will have trouble exiting when the time comes, it just means we have more choices to make, Dudley said.

OFFICIALS PUSH BACK ON AUDITS

Bernanke, who is in the midst of a contentious Senate confirmation process for a second four-year term as Fed chairman, used his remarks to push back against congressional proposals he argues would hurt the bank.

He praised the contribution the 12 regional Federal Reserve banks make to monetary policy by bringing insight into conditions around the country. Some lawmakers have proposed greater congressional control over those regional banks.

Bernanke and the New York Fed's Dudley also criticized a congressional proposal to audit Fed monetary policy decisions, saying it could undercut the Fed's independence.

The Senate Banking Committee held a hearing on Bernanke's nomination last week, but has not yet set a date for a vote. His current term expires on January 31.

(Additional reporting by Kristina Cooke in New York, Glenn Somerville and Pedro Nicolaci da Costa in Washington and Richard Leong in New York; Editing by Andrew Hay)

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