WASHINGTON - While financial markets, and the Obama administration, were buoyed by the decline in the U.S. unemployment rate in January to its lowest level in three years, Federal Reserve Chairman Ben Bernanke Tuesday cautioned that the drop to 8.3% "understates" the continued weakness of the jobs market.

"Our estimate of long-run employment of 5.2% to 6% is still quite far below 8.3% of course," Bernanke said during testimony before the Senate Budget Committee.

He noted that the unemployment rate does not reflect the significant number of people out of the labor force, or those forced to make do with just part-time work.

"So the 8.3% no doubt understates the weakness of the labor market in some broad sense," Bernanke said.

Bernanke launched a staunch defense of the Fed's actions to support the recovery, taking issue with those that say the central bank's policies have hurt growth.

"I think that our policy is strengthening the economy and that reduces uncertainty and increases the willingness of firms to hire and invest," he said.

For instance, Bernanke argued that while lower interest rates reduce the return for savers, that group also has holdings of corporate bonds, stocks and a variety of other securities.

"The returns on those securities depend very importantly on the strength of the economy," Bernanke said.

Driving down interest rates to almost zero also makes lending a more attractive proposition for banks he said, as the alternative is very low yielding U.S. Treasury securities.

As for the Fed's purchases of U.S. government debt, Bernanke said the effect on Treasury rates "is modest," and that rates will rise eventually.

"If investors were to lose confidence in U.S. federal fiscal policy, there's nothing the Fed could do to prevent those rates from rising," he said.

The Fed expects the unemployment rate to continue declining moderately, Bernanke said, but the economy will not grow at a pace fast enough to spark "sharp improvements" in the number of jobs created.

In addition, and in light of the mounting tension between the West and Iran, Bernanke warned that "a major disruption that sent oil prices up very substantially could stop the recovery.

"So it remains important to try to continue to support the recovery," he said.

And while some have tried to draw comparisons between the slow growth in the United States and conditions in Japan, Bernanke noted Japan's low population growth rates "is certainly going to be a factor that will keep their (economic) growth down in the period to come." 

Bernanke said the Fed is concerned that over the past few years there has been a "modest increase" in the sustainable long-run rate of unemployment, especially as skills get eroded among the long-term unemployed.

While there is not much that monetary policy can do to change this, Bernanke urged Congress to act, arguing that policies aimed at workforce skills, trade etc could bring down that rate.

Bernanke did pick out bright spots in the economy, noting for instance that the recovery in U.S. manufacturing "has been an encouraging development."

He also reaffirmed the Fed's commitment to its dual mandate of price stability and maximum employment, and repeated the projection of monetary policymakers that inflation will remain "very subdued" and will likely be at the 2% annual target, or below, both this year and in 2013.

Bernanke said employment is not the sole priority, assuring lawmakers that the Fed takes a balanced approach to its objectives. "We are certainly going to be working to bring both parts of our mandate towards desired levels," he said.

Pressed again on whether or not the Fed would ease off its price stability focus should progress on lowering the unemployment rate be less than satisfactory, Bernanke reiterated that the Fed will not seek higher inflation in order to boost employment.

Both objectives interact, he said, noting that if unemployment is high, it could affect the speed at which the Fed returns inflation to its target, but the same would apply if the roles were reversed.

The majority of the hearing focused on the precarious nature of current U.S. fiscal policy, and Bernanke repeatedly emphasized that the nation needs a plan that "credibly and strongly" articulates how fiscal policy will be made sustainable. Such a plan, however, must be phased in gradually to avoid throwing the recovery off course.

Most of the problems in the U.S. fiscal path arise after the next 10 years, he warned, and the U.S. federal deficit will become unsustainable on its current path in 15 to 20 years at the most.

However, "a sharp change" in the fiscal stance of the government in a short time span -- through an expiration of tax cuts or via sequestration -- and without any compensating actions to mitigate the effect "would indeed slow the recovery," Bernanke said.

This underlines why Congress must shift its efforts to achieving fiscal sustainability over the long-run, he added.

"These are concerns which are not just about our children 20 years from now, but they could have effects much sooner if markets begin to lose confidence in our nation's ability to stabilize our debt burden," Bernanke said.

He noted that financial markets have focused not so much on the size of the U.S. debt load, but the partisan battles that have come to characterize the country's political process.

"A strong demonstration by Congress and the administration that they understand these issues, and they have a plan for attacking them, I suspect would go a long way to maintaining confidence in the bond market," Bernanke said.

Market News International is a real-time global news service for fixed-income and foreign exchange market professionals. See www.marketnews.com.

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