How Bernanke would fine-tune the economy

Against this backdrop, Bernanke used his Senate appearance to promote his goal of formal inflation objectives and of flexibility in Fed policymaking.

"I do not subscribe to any rigid and mechanical rule" for setting interest rates, Bernanke told senators. "I intend to be flexible and to learn from experience."

Citing the Fed's current policy path under Greenspan, he said "the right starting point ... is where we are."

He affirmed not only continuity with Greenspan but also support for the Fed's "dual mandate" from Congress to promote both stable prices and full employment.

The best way to achieve those twin goals, he said, is to maintain low inflation and level expectations about future prices.

He said he would have to build consensus within the Fed before using an explicit inflation target as a tool to reach that goal.

He opened his testimony on another closely watched note: an assertion of Federal Reserve independence from Capitol Hill politics. He said he would not comment on specific tax policies, for example, but said "I agree that budget deficits are a problem."

David Wyss, chief economist at Standard & Poor's in New York, says Fed officials naturally are reluctant at first to weigh in on issues beyond the agency's official mandate. Yet often, over time, they become more willing to opine on such matters.

That can be good or bad, depending on one's view. It can be sometimes be useful, Mr. Wyss says, to have an unofficial economist-in-chief, speaking from a vantage point somewhat removed from politics.

In addition to an economy burdened by rising entitlement costs as baby boomers retire, Bernanke will face other possible challenges - some of which were the subject of questions Tuesday:

• The trade deficit. The nation's balance sheet with the rest of the world is in record deficit territory. Asked if he was alarmed by that, Bernanke simply said the imbalance would have to be corrected over a period of time. For now, trading partners such as China and Japan are willing to hold the dollars they receive from an import-hungry US.

• Housing prices. American consumers have hefty deficits of their own, often tapping lines of credit based on home prices that have risen in recent years. Now, as the Fed raises interest rates, the housing market appears to be softening. Amid concerns about a real estate "bubble" in parts of the US, "the Fed won't cry if home prices flatten," Wyss says. But the process could put a damper on consumer spending.

• Financial markets. Some experts say a long era of low and stable interest rates may have created an environment where private-sector financiers have become complacent about some of the risks they take. The results could be big losses by financial companies that show up only during an economic downturn.

"If the economy turns down we may have more severe credit problems," says Dr. Rajan of the IMF. He says it's not clear how big these risks are, but in his view, the Fed should be watchful in its role as a regulator of the financial sector.

Fed chiefs in the past have often faced significant tests early in their tenure.

Consider Greenspan: "Within two months he had a stock market break, which in one day wiped out about one quarter of the value of the stock market," says Allan Meltzer, an economist and historian of the Fed at Carnegie Mellon University in Pittsburgh.

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