The Federal Reserve could begin pulling back its unprecedented stimulus for the U.S. economy by first removing some cash from the financial system and then raising interest rates, Fed Chairman Ben Bernanke said on Wednesday.

The U.S. central bank has pumped more than $1 trillion into the economy after it slashed benchmark rates to near zero to combat the worst financial crisis since the Great Depression.

While the economy has grown for the past two quarters, unemployment is at a lofty 9.7 percent. In his most detailed description to date of how the Fed aims to dismantle the extensive emergency support facilities it put in place during the crisis, Bernanke made clear the Fed's thinking on its exit strategy had advanced even though the time for tightening monetary policy was still some ways away.

Although at present the U.S. economy continues to require the support of highly accommodative monetary policies, at some point the Federal Reserve will need to tighten financial conditions, Bernanke said in remarks prepared for a hearing of the House of Representatives Financial Services Committee.

The hearing was postponed because of heavy snow that shut down transportation in Washington, but the Fed decided to go ahead and make Bernanke's testimony public.

Bernanke said exit steps include the likely widening, soon, of the gap between the discount rate the Fed charges banks for emergency loans and the overnight interbank federal funds rate, its main policy tool. The Fed pulled the discount rate closer to the fed funds rate during the severe credit crunch to encourage banks to use it to obtain short-term funding.

U.S. stock indexes read the Fed chairman's comments as hinting at a rise in interest rates and added to losses, while the dollar gained against the dollar and the yen.

They seem to be softening the beaches a little bit with rhetoric that even if they start raising interest rates they have a long way to go just to get policy back to neutral, so I think they are trying to get the market ready for that, said Mark Vitner an economist at Wells Fargo Securities in Charlotte, North Carolina.

Primary dealers polled by Reuters last week expect the Fed to raise rates in the final three months of this year.

Bernanke said the Fed could begin by testing tools to absorb the massive amount of reserves it had pumped into the banking system, such as reverse repurchase agreements and term deposits for banks at the central bank, in small amounts to prepare markets, Bernanke said.

As the time to tighten financial conditions drew nearer, the Fed could ramp up reserve-draining operations. Shrinking the central bank's bloated balance sheet would give policymakers tighter control over short-term interest rates, Bernanke said.

Ultimately, the Fed would increase the rate it pays on reserves banks hold at the central bank as its way to take its foot off the wide-open monetary accelerator pedal. Raising the interest rate on reserves would encourage banks to park funds with the Fed, taking the money out of circulation.

The Fed has greatly expanded its balance sheet with purchases of mortgage-related debt as part of its efforts to revive the economy. Those mortgage-related assets are on track to total $1.45 trillion by the end of March, when the buying is due to end.

Bernanke said the Fed is not likely to sell any of those holdings in the near term, at least not until after policy tightening has gotten under way and the economy is clearly in a sustainable recovery.

However, when the recovery has advanced and more tightening is needed, the Fed could sell securities, Bernanke said. Any such sales would likely be gradual and markets would receive ample warning, he said.

The Fed will also return its vast array of emergency lending measures to pre-crisis norms, including raising the discount rate and shortening the duration of loans at its emergency lending window, Bernanke said.

The Fed expects before long to consider a modest increase in the gap between the discount rate and the fed funds rate, he said.

Before the crisis hit in the summer of 2007, the discount rate was 1 percentage point higher than the benchmark borrowing costs. The discount rate is now 0.5 percent while the fed funds rate is between zero and 0.25 percent.

Changes to the discount window should be viewed as steps to normalize lending, not a change in the outlook for monetary policy or an effort to tighten financial conditions, Bernanke stressed.

The outlook for monetary policy currently remains about the same as it was at the Fed's last policy meeting on January 26-27, he said. At that meeting, the Fed held rates near zero and promised to keep them exceptionally low for an extended period. Bernanke repeated that pledge on Wednesday.

With the Fed's balance sheet abnormally large, controlling the fed funds rate can be difficult, Bernanke said. During the transition, the Fed will likely communicate its policy stance through an alternative short-term interest rate, he said.

It is possible that the Federal Reserve could for a time use the interest paid on reserves, in combination with targets for reserve quantities, as a guide to its policy stance, Bernanke said.

(Additional Reporting by Chris Reese; Editing by Andrea Ricci)

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