Federal Reserve Chairman Ben Bernanke told Congress Wednesday the economy should grow modestly this year and inflation should continue to wane, reasons enough for the central bank to keep interest rates steady for the time being.

Still, Bernanke wasn't prepared to declare victory over inflation just yet and thus didn't close the door on the possibility of further interest rate increases down the road. Even with recent improvements in "core" or underlying inflation, the situation remains "somewhat elevated," he said.

Delivering the Fed's first economic report for 2007 to Capitol Hill, Bernanke offered a mostly upbeat assessment of the economy's outlook. Besides improvements on the inflation front, the Fed chief also cited some signs of stabilization in the ailing housing market.

"Overall, the U.S. economy seems likely to expand at a moderate pace this year and next, with growth strengthening somewhat as the drag from housing diminishes," the Fed chief told the Senate Banking Committee.

Currently, interest rates are at a level that is "likely to foster sustainable economic growth and a gradual ebbing of core inflation," he added.

The Fed has held a key interest rate steady at 5.25 percent since August. Before that, the central bank had steadily boosted rates for two years, the longest ever stretch of increases, to fend off inflation. Many economists predict the Fed will leave rates alone for much of this year and said the Fed chief's testimony would support that approach.

Even with his mostly positive assessment, Bernanke was careful to hedge his bets and pointed out risks that could upset the generally good economic outlook.

A predominant one is that inflation might flare up, which is why the Fed is still keeping open the option of another rate increase.

It will "be some time before we can be confident that underlying inflation is moderating as anticipated," Bernanke said. If inflation doesn't wane as the Fed expects, policymakers are "prepared to take action," Bernanke said.

On the other hand, there is the risk that a deeper than expected residential real-estate bust could yet unfold, which could hurt overall economic growth, the Fed chairman said. If that were to happen, the Fed in theory might be inclined to lower rates to help bolster the economy.

Bernanke, however, did not specifically mention the possibility of a rate cut.

A former college professor, Bernanke marked his one-year anniversary at the Fed on Feb. 1. President Bush tapped him to succeed longtime Chairman Alan Greenspan, who rose to iconic status in his 18-plus years at the helm of the Fed.

Senate Banking Committee Chairman Christopher Dodd, D-Ct., who holds White House aspirations, as well as other senators on the panel said they thought Bernanke was doing a good job thus far in managing the world's largest economy.

However, Dodd said he hopes to gain insights from Bernanke on the state of the middle class in the country. "People are working longer and harder but many are not bringing home enough money to keep pace with what they need," Dodd said.

Democrats, who are in control of Congress for the first time in 12 years, accuse Bush of not doing enough to narrow economic inequality, which has widened over the past few decades. Finding ways to close that gap between low- and high-income workers is a Democratic priority.

Bernanke said that bolstering education and helping workers acquire new skills should help the situation.

On trade, Bernanke said he is not happy with the United States' record-high deficits but suggested erecting protectionist barriers would do more harm than good.

China, he said, needs to do more to move to a flexible currency policy. Critics contend that Beijing is keeping its currency artifically low, giving it an unfair trade advantage, and thus hurting U.S. exports and contributing to the loss of U.S. factory jobs.

When asked about Japan, a huge competitive force for the troubled U.S. auto sector, Bernanke said the Fed has seen no evidence that the country is manipulating the yen to keep its value low.

Bernanke refused to weigh in on tax policy, much to the dismay of Sen. Charles Schumer, D-N.Y., who said to the Fed chief: "I think you are ducking it with all due respect."

In its latest economic projections, the Fed said that it expects the economy this year to grow between 2.5 percent and 3 percent — as measured from the fourth quarter of last year to the fourth quarter of this year. That would be slower than a previous Fed forecast and less than the 3.4 percent growth logged for all of 2006.

"Core" inflation, meanwhile, should ease to between 2 percent to 2.25 percent, which would be down from 2.3 percent last year. Core inflation excludes the more volatile categories of energy and food.

The unemployment rate may creep up a bit this year and rise as high as 4.75 percent, which would still be low by historical standards.

Sen. Richard Shelby, R-Ala., said that when Bernanke took the Fed helm last year there was debate over whether the central bank could successfully accomplish a tricky maneuver: getting the economy to slow sufficiently to thwart inflation but not so much as to fall into recession. "The economic data in recent weeks tells us that the debate is all but over," Shelby said.