The Federal Reserve stands ready to ease monetary policy further if the budding U.S. economic recovery withers, Fed Chairman Ben Bernanke said on Wednesday, describing the outlook as unusually uncertain.

Policymakers, however, still expect growth to be sustained despite a recent softening in the economy, Bernanke said in congressional testimony, playing down the risk of renewed recession and the possibility of deflation.

We remain prepared to take further policy actions as needed to foster a return to full utilization of our nation's productive potential in a context of price stability, he told the Senate Banking Committee.

Nonetheless, Bernanke said the U.S. central bank was continuing prudent planning for the ultimate withdrawal of monetary policy accommodation.

The Fed has kept interest rates near zero percent since December 2008 and has bought more than $1.5 trillion in mortgage and Treasury bonds to fight the deep recession and virulent financial crisis.

The economy resumed growth about a year ago, but stubbornly high unemployment, a fresh drop in housing activity and a slowdown in manufacturing have raised fears of a double-dip recession.

Although Bernanke said the chances of a fresh downturn were not high, stocks retreated as he testified, with major averages <.DJI> <.SPX> dropping more than 1 percent. Some investors were surprised by the Fed chief's candid admission of lingering uncertainty. Others were taken aback by the tentative nature of the Fed's plans for further easing.

Reaction is basically turning into a spasm of despair. The market was looking for some form of concrete action from Bernanke, a commitment to do something, said Brian Dolan, chief currency strategist at Forex.com in Bedminster, New Jersey. All we got was that they're aware of the risks and are prepared to take as yet unspecified actions.

Bond prices rallied, with the yield on the benchmark 10-year note hitting 2.86 percent, the lowest since April 2009.

Pressed on what the Fed could do to ease monetary policy further, Bernanke said it could reinvest mortgage bonds that are rolling off its balance sheet or engage in further debt purchases. It could also lower the rate it pays banks to park their excess reserves at the Fed, he said.

If the recovery seems to be faltering, then we at least need to review our options. We have not fully done that review, he said.

While Bernanke left the door open to further easing as he delivered the central bank's semiannual monetary policy report to Congress, he made clear officials were still banking on a sustained, if sluggish, economic rebound.

Although fiscal policy and inventory restocking will likely be providing less impetus to the recovery than they have in recent quarters, rising demand from households and businesses should help sustain growth, he said.

For now, he said the Fed expects economic conditions will warrant an exceptionally low benchmark federal funds rate for an extended period -- repeating a vow the central bank has kept in place for more than a year.

Bernanke said a weak job market was acting as a drag on consumer spending, and it would take a long time before the economy can restore the nearly 8.5 million jobs lost in 2008 and 2009.

Against that backdrop, he indicated inflation was not a concern and was unlikely to become a problem any time soon. Asked about the threat of deflation -- a broad, sustained decline in prices that could prove economically crippling -- Bernanke said he did not believe it would become a concern.

Policymakers expect continued moderate growth, a gradual decline in the unemployment rate, and subdued inflation over the next several years, Bernanke said.

Minutes of the Fed's last policy-setting meeting in late June released last week showed officials had downgraded their economic forecasts. Bernanke said most officials saw risks to the downside.

Lawmakers tried repeatedly to get Bernanke to endorse their respective views on budget deficits; Republicans want to see near-term action to rein in red ink, while some Democrats want more spending to support the economy.

But Bernanke was non-committal. He said the economy needed the fiscal stimulus it got but that a long-term plan for a sustainable fiscal path was crucial to hold interest rates down.

Asked about Beijing's currency policy, he said the United States would like to see the Chinese yuan appreciate considerably further but warned Congress against actions that could inflame trade relations.

In discussing how the Fed might go about eventually removing the extraordinary stimulus it has provided the economy, Bernanke said there was broad agreement among officials that asset sales will eventually play a role. He said any sales would be flagged well in advance.

(Additional reporting by Emily Kaiser; editing by Tim Ahmann, Leslie Adler, Andrew Hay.)

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