WASHINGTON- Federal Reserve Chairman Ben Bernanke on Thursday kept the door open to further interest rate reductions, saying downside risks to economic growth remain from housing, employment and credit markets.

But he appeared more upbeat on the economy's prospects for later this year and next year when the combination of fiscal and monetary stimulus kicks in.

"At present, my baseline outlook involves a period of sluggish growth, followed by a somewhat stronger pace of growth starting later this year as the effects of monetary and fiscal stimulus begin to be felt," Mr. Bernanke said in prepared testimony to the Senate Banking Committee.

But even though he envisions "an improving picture" on the economy, Mr. Bernanke cautioned that "downside risks to growth remain, including the possibilities that the housing market or the labor market may deteriorate to an extent beyond that currently anticipated, or that credit conditions may tighten substantially further."

The Federal Open Market Committee, he said, "will act in a timely manner as needed to support growth and to provide adequate insurance against downside risks." He also signaled that policy moves in the future will depend on the Fed's medium-term forecast for growth and inflation "as well as the risks to that forecast," since policy works with a lag.

Economists expect more rate cuts in coming months as the economy hovers near recession. Recent reports including a drop in January payrolls and a contraction in the Institute for Supply Management's service-sector survey last month raised recession alarms. However, a better-than-expected retail sales report for January, released Wednesday, suggested the economy may be able to eke out some expansion this quarter.

The FOMC has lowered the fed funds rate at which banks lend to each other "aggressively," Mr. Bernanke said, by 2.25 percentage points to 3% since September, including 1.25 percentage points in reductions over an eight-day period in January.

Meanwhile, a surprising drop in the December trade deficit reported Thursday suggests fourth-quarter growth will be revised up from its initial estimate of 0.6%.

But Mr. Bernanke cautioned that consumers face headwinds in coming months. Labor markets have "softened," he said -- citing the decline in January payrolls. Plus, higher energy costs, lower equity prices and falling home values "seem likely to weigh on consumer spending in the near term," he said. More homebuilding cutbacks, meanwhile, "are likely," he added.

However, consumer and business spending should get some support in the second half of this year and into 2009 from the recently approved fiscal stimulus package, Mr. Bernanke said.

Turning to inflation, Mr. Bernanke said a "key development" in 2007 was the "steep" rise in oil prices. Food prices also increased "exceptionally rapidly" while "the foreign exchange value of the dollar weakened," Mr. Bernanke said.

Mr. Bernanke said he expects inflation to moderate, "and the public's longer-term inflation expectations should remain reasonably well anchored."

But he warned that "any tendency of inflation expectations to become unmoored or for the Fed's inflation-fighting credibility to be eroded could greatly complicate the task of sustaining price stability and reduce the central bank's policy flexibility to counter shortfalls in growth in the future."

by Brian Blackstone, Dow Jones Newswires