Federal Reserve Chairman Ben Bernanke Tuesday said the outlook for the long-suffering U.S. economy was improving, but supportive policies would be needed for some time to prevent rising unemployment from undercutting recovery.

Delivering the Fed's semiannual report on the economy to Congress, Bernanke also sought to dispel concerns the U.S. central bank's aggressive monetary easing could end up fueling inflation, saying he was confident the Fed could pull back its extraordinary stimulus when the time was right.

Better conditions in financial markets have been accompanied by some improvement in economic prospects, Bernanke told the House of Representatives Financial Services Committee. Despite these positive signs, the rate of job loss remains high.

While housing and household spending appear to be stabilizing, unemployment is likely to remain uncomfortably high into 2011 and could sap fragile consumer confidence, he warned.

The (Fed) believes that a highly accommodative stance of monetary policy will be appropriate for an extended period, Bernanke said.

The sober assessment weighed on U.S. stocks, and major indexes were close to flat in midafternoon.

But government bond prices got a lift as Bernanke poured cold water on the idea the Fed might begin to raise rates this year, while also assuring investors policy-makers would not let the inflation genie out of the bottle.

Bernanke is hitting the right notes in the mind of the market, said Cary Leahey, an economist at Decision Economics in New York. Bernanke said there's an exit strategy from monetary ease if needed, but he also told Congress he cares about getting the economy back on its feet.

WE HAVE THE NECESSARY TOOLS

The Fed has cut interest rates to almost zero and doubled the size of its balance sheet to around $2 trillion as it pumped money into the economy to fight a severe recession after a financial panic last year cracked global credit markets.

Some economists have worried that this dramatic expansion of Fed liquidity and lending may have sown the seeds for inflation as the recovery gains traction.

Bernanke, however, said the central bank had an array of weapons at its disposal to withdraw monetary stimulus when the time was right.

The (Fed) has been devoting considerable attention to issues relating to its exit strategy, and we are confident that we have the necessary tools to implement that strategy when appropriate, he said, echoing comments he made in an article published late Monday on the Wall Street Journal's website.

We will not allow the broad measures of money circulating in the economy to rise at a rate rapid enough that would cause inflation eventually.

Lawmakers pressed Bernanke on a wide range of issues -- from the economy to regulatory reform to health care -- but in general treated him with far more deference than the last time he testified on Capitol Hill at a hearing on the Fed's role in Bank of America's purchase of Merrill Lynch.

The Fed has been a sturdy, methodical hand, said Representative Melvin Watt, a North Carolina Democrat.

Bernanke told the panel that paying interest on the reserves banks hold at the Fed would play a key role in helping the central bank tighten monetary conditions when the time comes. By increasing the amount of interest it pays, the Fed can encourage banks to park excess cash at the central bank.

The Fed's monetary policy report detailed a number of other measures that Bernanke also outlined in his newspaper piece.

The report said the Fed could arrange so-called reverse repurchase agreements with financial firms. The Fed would sell securities from its portfolio, taking cash out of the system, with an agreement to buy them back later at a higher price.

It could also offer term deposits similar to certificates of deposit to banks. Bank funds held at the Fed in such instruments would not be available for lending.

In addition, the Treasury Department could issue securities and leave the funds on deposit with the Fed, or the Fed could sell some of the securities it has accumulated.

(Reporting by Mark Felsenthal and Alister Bull; Editing by Editing by Tim Ahmann and Chizu Nomiyama )

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