Housing's in the tank, banks are scared to lend, but oil is at $100 a barrel and inflation is threatening to pick up -- what's a central banker to do?

Federal Reserve Chairman Ben Bernanke will deploy his most reassuring bedside manner in congressional testimony on Wednesday and Thursday to explain how the U.S. central bank, which has already cut interest rates 2-1/4 percentage points since mid-September, can trim them further to prevent recession without letting inflation get out of hand.

Near-term, the economy remains extremely vulnerable to further contraction because business sentiment has deteriorated further and the aggressive Fed easing to date has been partially offset by tighter financial conditions, Deutsche Bank economists wrote in a note to clients. This means the Fed is going to have to cut rates further, which is the message Mr. Bernanke will deliver.

Financial markets place a 92 percent chance of a half-point cut in benchmark rates at the Fed's next meeting on March 18, as implied by short-term interest-rate futures. Bernanke's testimony on the central bank's semiannual report on monetary policy and the economy will be closely scrutinized for clues on whether those bets are on the mark.

INFLATION UNEASE

Worried that financial turmoil would undercut an already weak economy, the Fed chopped rates by three-quarters of a point in an emergency move on January 22, just eight days before a regularly scheduled meeting.

It lowered them by another half point when its January 29-30 meeting wrapped up -- a one-two punch that marked one of the most aggressive easings of monetary policy in the central bank's modern history.

At the same time, policy-makers were taking note of a rise in prices that has taken inflation above the 'comfort zone' of a number of Fed officials. Most, however, believed a period of sluggish growth would draw some inflationary pressure out of the system, minutes of the central bank's last meeting said.

Underscoring the Fed's dilemma, the Consumer Price Index, released on Wednesday, showed a worrisome 4.3 percent rise in prices in the 12 months through January.

While surging energy and foods costs accounted for much of the gain, core prices, which strip out energy and food, were up 2.5 percent, the most since last March.

Rising prices are pinching consumers at exactly the same time that employment is slowing and the housing market is struggling, economic consultant Carl Tannenbaum said in a research note.

If growth rebounds quickly after the current soft patch (not altogether unlikely, given the amount of fiscal and monetary stimulus in the pipeline), the Fed may find itself having to raise rates aggressively later on this year to keep prices under control, Tannenbaum said.

GROWTH FORECAST CUT, INFLATION RAISED

In updated economic forecasts released last week, the U.S. central bank lowered its outlook for 2008 growth by a half point to between 1.3 percent and 2 percent, citing the prolonged housing slump and bottlenecks in credit markets.

However, it also raised projections for both core and overall inflation, a recognition of the tough environment officials face. While the central bank lowers rates to spur growth, it would usually raise them to combat inflation.

Bernanke's commentary this week will be scoured for signs of how the Fed plans to respond to risks to growth, financial instability, and rising price pressures.

We have seen deterioration on all three fronts, so the key to the testimony will be how Bernanke perceives the Fed's next moves in light of ultimately fighting battles on all three fronts, Global Insight economists told clients.

While Bernanke is expected to show the Fed focused primarily on downside risks to growth, as he did in testimony less than two weeks ago, he is also expected to nod to the inflation concerns some officials have begun to highlight.

Dallas Federal Reserve Bank President Richard Fisher, a voter on the Fed's interest-rate setting committee, said on Friday that while growth could be slower than the central bank expects, officials needed to be vigilant on inflation risks.

We have to be mindful of that fact that we have to create the conditions for employment growth, at the same time be careful that we don't stir the embers of inflation, and that represents the horns of a dilemma recently, he said.

(Editing by Maureen Bavdek)

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