Oct. 8 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke said the central bank will be prepared to tighten monetary policy when the outlook for the economy “has improved sufficiently.”

“My colleagues at the Federal Reserve and I believe that accommodative policies will likely be warranted for an extended period,” Bernanke said in prepared remarks at a Board of Governors conference today in Washington, echoing language from last month’s meeting of the Federal Open Market Committee. “At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road.”

The Fed chairman didn’t enter into the debate among his colleagues on the FOMC over the timing of a change in monetary policy. Fed Governor Kevin Warsh said Sept. 25 interest rates may need to rise “with greater force” than usual, while New York Fed President William Dudley said Oct. 5 the recovery’s pace “is not likely to be robust” and inflation risks are “on the downside.”

The FOMC reiterated its pledge last month to keep the benchmark lending rate at around zero “for an extended period” to boost a weak recovery that has yet to create jobs. The unemployment rate rose to 9.8 percent last month, the highest level since 1983. Bernanke didn’t discuss the outlook for the economy in his prepared remarks, which outlined the Fed’s response to the financial crisis.

Euro, Yen

The dollar climbed against the yen and euro after Bernanke’s comments. The U.S. currency advanced to 88.67 against the yen as of 8:36 a.m. in Tokyo from 88.39 in New York. The dollar rose to $1.4775 per euro from $1.4794.

U.S. stocks gained as Alcoa Inc. started the earnings season with an unexpected profit and jobless claims decreased more than forecast. Gold climbed to a record as the dollar weakened to the lowest level in almost 14 months against six major trading partners. Treasuries fell.

The Standard and Poor’s 500 Index rose 0.8 percent to 1,065.48. Yields on U.S. 10-year notes increased 7 basis points to 3.25 percent in late New York trading. A basis point is 0.01 percent.

The Fed staff is fine-tuning mechanisms designed to drain or neutralize excess cash in the banking system following a doubling in the central bank’s balance sheet. Those tools range from paying interest on bank reserves deposited at the Fed to reverse repurchase agreements, where the Fed pulls cash out of the financial system through a temporary sale of securities.

Balance Sheet

U.S. central bankers boosted their balance sheet by $1.2 trillion after the collapse of Lehman Brothers Holdings Inc. in September 2008. The Fed has provided emergency credit to markets for commercial paper and asset-backed securities, expanded loans to banks and financed a $30 billion pool of high-risk securities to facilitate the merger of Bear Stearns Cos. with JPMorgan Chase & Co.

The Fed chairman said the bank reserves created through these operations haven’t created growth in broader measures of money. Still, Fed actions he said have improved liquidity and reduced lending spreads, two measures of success for a policy he calls “credit easing.”

“The unstinting provision of liquidity by the central bank is crucial for arresting a financial panic,” Bernanke said. “By backstopping these markets, the Federal Reserve has helped normalize credit flows for the benefit of the economy.”

Purchase Program

To keep longer-term interest rates low, the Federal Open Market Committee is also conducting a $1.75 trillion purchase program of Treasury, housing agency and mortgage-backed securities.

“The principal goals of our recent security purchases are to lower the cost and improve the availability of credit for households and businesses,” Bernanke said. “The programs appear to be having their intended effect.”

The average rate on a 30-year fixed-rate mortgage fell to 4.87 percent, the lowest since May, Freddie Mac said today. The Fed’s auctions of term loans to banks are also reducing pressures in the market for interbank loans. The London interbank offered rate, or Libor, for three-month dollar loans was 0.284 percent today, down from 1 percent May 1.

The Fed won’t begin raising interest rates until the third quarter of 2010 as the recovery is likely to be too weak to lift employment and incomes, according to a September survey of 57 economists by Bloomberg News.

Risk of Relapse

Richmond Fed President Jeffrey Lacker told reporters at a separate event in Washington today that the risk the economy will slide back into recession “has diminished substantially” yet is “not entirely zero.”

Lacker also said Oct. 1 in a Bloomberg Radio interview that the growth and consumer spending outlook are “more fundamental” to the decision on when to tighten than “labor- market conditions.”

Fed Governor Daniel Tarullo said today in a speech in Phoenix that the strength of the U.S. recovery shouldn’t be exaggerated, while reiterating that rates are likely to remain low for “an extended period.”

“This turnaround is certainly welcome, but it should not be overstated,” Tarullo said. “Although we can expect positive growth to continue beyond the third quarter, economic activity remains relatively weak.”

The economy will expand at a 2.2 percent annual pace this quarter, the economists estimated. Housing markets have stabilized and manufacturing is picking up as companies re-stock lean inventories. Employers cut 263,000 jobs in September, pushing the unemployment rate up to 9.8 percent.

Unemployment Rate

“The unemployment rate is much too high and it seems likely that the recovery will be less robust than desired,” New York Fed President William Dudley said Oct. 5. “This means that the economy has significant excess slack and implies that we face meaningful downside risks to inflation over the next year or two.”

Consumer prices have fallen for six straight months from year-earlier levels, the longest stretch of declines since a 12- month drop from September 1954 to August 1955, according to the Labor Department.

The core consumer-price index, which excludes food and energy, rose 1.4 percent in August from a year earlier, down from a 2.5 percent increase in September 2008.

“There is still downward pressure on core inflation and with the unemployment as weak as it is, there is a lot of room, as the Fed sees it, to maintain exceptionally low interest rates,” said Dan Greenhaus, chief economic strategist at Miller Tabak & Co. LLC.

To contact the reporter on this story: Craig Torres in Washington at ctorres3@bloomberg.net; Scott Lanman in Washington at slanman@bloomberg.net.

Last Updated: October 8, 2009 19:38 EDT