While Bernanke welcomed the recent drops in oil and other commodities' prices, and believes inflation will moderate this year and next, the Fed chief also warned the inflation outlook remains highly uncertain.
The Fed, he said, would monitor the situation closely and will "act as necessary" to make sure that inflation doesn't get out of hand.
The current financial and economic environment is one of the most challenging to Fed policymakers "in memory," he acknowledged.
Given those dueling economic cross-currents- weak economic growth and higher inflation - many economists believe the Fed will leave rates where they are at its next meeting on Sept. 16, and probably through the rest of this year.
"They won't act until the coast is clear on financial stability and the state of the economy," said Allen Sinai, chief global economist at Decision Economics Inc. Many fear the economy will hit a rough patch later this year as the bracing effect of the government's tax-rebate checks fades.
Wall Street was buoyed by Bernanke's hope that inflation will calm down, a dip in oil prices and growing speculation that Lehman Brothers Holdings Inc. could be sold. The Dow Jones industrial average closed up 197.85 points at 11,628.06. Broader stock indicators also posted gains.
The economy is the top concern for voters and of keen interest to presidential contenders Sens. Barack Obama and John McCain, who are gearing up for their party's conventions. Financial and credit problems are expected to smolder into next year. And, the unemployment rate, which jumped to a four-year high of 5.7 percent in July, is expected to keep rising.
The bulk of Bernanke's speech dealt with the need to bolster oversight of the nation's financial system to make it better able in the future to withstand future shocks.
To that end, Bernanke recommended that regulators work on ways to assess the health of the entire financial system, rather than the condition of individual banks, Wall Street investment firms or other financial companies - as is currently the focus.
"Such an approach would appear well justified as our financial system has become less bank centered," he said. "Some caution is in order, however, as this more comprehensive approach would be technically demanding and possibly very costly both for the regulators and the firms they supervise." He added that "stress tests" for a range of financial firms might also be helpful.
Bernanke's remarks come amid renewed worries on Wall Street about the financial health of Fannie Mae and Freddie Mac. The mortgage giants' stocks were hammered this week as investors became increasingly convinced a government bailout is inevitable.
Although the Fed chief didn't mention the companies, he said one of the critical questions facing the country is how to strengthen the financial system and at the same time protect against "moral hazard," where financial companies might feel more inclined to gamble with risks because they believe the Fed or the government will ultimately bail them out.
"Some particularly thorny issues are raised by the existence of financial institutions that may be perceived as 'too big to fail,' and the moral hazard issues that may arise when governments intervene in a financial crisis," Bernanke said.
Bernanke repeated his call for Congress to provide new regulatory powers to insulate the economy from damage if a Wall Street firm collapses. He again urged lawmakers to give the central bank explicit authority to oversee systems that process payments and other financial transactions by investment firms and banks.
The Fed's handling of the credit, financial and housing debacles is spurring debate at this year's forum, which draws Fed policymakers, economists, academics and international central bank officials.
The Fed has taken unprecedented steps over the past year to battle the nation's worst credit and financial crises in decades.
To brace the wobbly economy, the central bank has slashed its key interest rate by 3.25 percentage points, the most aggressive rate-cutting campaign in decades. Those rate cuts aggravated inflation, though.
Charles Calomiris, professor at Columbia University's Graduate School of Business, believes the Fed should be more focused on inflation fighting: "The Fed needs to raise (interest rates) now, slowly and predictably to restore confidence in its continued commitment to price stability."
The Fed also has taken some debatable action to stabilize the shaky financial system and get credit - the economy's lifeblood - flowing more freely.
The Fed agreed in March to let investment houses draw emergency loans directly from the central bank, and last month extended that option to Fannie and Freddie. For years, such lending privileges were extended only to commercial banks.
Critics question whether taxpayers are being put at risk and if expanded safety nets will encourage financial companies to act more recklessly in the future.
But Bernanke on Friday again defended the Fed's decisions saying they were needed to avert a financial catastrophe that could have plunged the economy into a deep recession.