U.S. industrial output fell 0.2 percent in January as warm weather slashed power usage, Federal Reserve data showed Wednesday, but higher manufacturing production and strong capacity use fanned inflation fears.

Shortly after the report was released, new Fed Chairman Ben Bernanke told Congress that the U.S. economy was running so close to capacity that it faced increasing inflation risks that could require higher interest rates.

The Fed said utility output fell 10.1 percent in January, the largest monthly decline in the 34-year history of the Fed's industrial production index.

But excluding output from utilities, January output from U.S. factories and mines would have been 0.8 percent higher, the Fed said.

Wall Street economists had forecast that overall industrial production for January would climb 0.3 percent.

"The warm weather meant that utilities didn't have to produce the seasonal norm, which occasionally happens in the wintertime," said Gary Thayer, chief economist at A.G. Edwards & Sons Inc. in St. Louis.

"Consumer durables production is looking solid, so it's looking like there's still going to be strong first quarter GDP growth," he said.

While the weather-related fall in utility output caused closely watched industrial capacity utilization to dip to 80.9 percent, it still topped economists' forecasts for 80.8 percent utilization. December's capacity use rate was revised to 81.2 percent from a previously reported 80.7 percent.

And manufacturing capacity use was 80.5 percent in January, the highest level since July 2000.

Bernanke, in testimony to the U.S. House of Representatives Financial Services Committee, said inflation risks were lurking.

"The risk exists, that, with aggregate demand exhibiting considerable momentum, output could overshoot its sustainable path, leading ultimately — in the absence of countervailing monetary policy action — to further upward pressure on inflation," he said.

He added that Gulf Coast reconstruction following hurricanes last year may make 2006 economic growth stronger than previously thought.

"If the housing market does cool more or less as expected, that would still be consistent with a strong economy in 2006 and 2007," he said, adding that increased capital investment by businesses would offset lower residential investment.

U.S. Treasury debt prices erased all of their gains after Bernanke's inflation warning. Ten-year notes (US10YT-RR) stood 1/32 lower to yield 4.618 percent, compared with 4.612 percent on Tuesday.

Overall manufacturing output rose 0.7 percent in January, while mining output rose 1.7 percent. Durable goods production in January also rose 0.7 percent, aided by a 2.3 percent increase in automotive output and a 3.0 percent increase in production of electrical equipment, appliances and components.

Nondurable manufacturing output rose 0.7 percent in January, with petroleum and coal products up 3.6 percent, chemicals up 1.1 percent and textiles up 1.6 percent.

"This level of growth should lead to a further tightening of the labor market and that could power faster wage gains," said Joel Naroff, president of Naroff Economic Advisers in Holland, Pennsylvania.

The dollar edged higher on growing expectations of higher U.S. interest rates.

Earlier, the currency had slipped after the U.S. Treasury Department reported that net flows of capital into U.S. assets fell to $56.6 billion in December, short of the $65.7 billion U.S. trade deficit that month. Analysts had expected net inflows to ease far less, to $82.3 billion from November's $91.6 billion

The report is watched by markets as a sign of whether foreign appetite for U.S. assets matches U.S. consumption of goods and services abroad.

A separate index report from the New York Federal Reserve indicated that manufacturing growth at New York state factories ticked higher in February, exceeding expectations, but the employment component of the index dropped.