* Fed cognizant of bond-buying risks, but benefits outweigh * Bernanke warns on impact of scheduled budget cuts * Bernanke's defense of stimulus helps support stock markets By Pedro da Costa and Alister Bull WASHINGTON, Feb 26 (Reuters) - Federal Reserve Chairman Ben Bernanke strongly defended the U.S. central bank's monetary stimulus before Congress on Tuesday, easing financial market worries over a possible early retreat from bond purchases. Bernanke said Fed policymakers are cognizant of potential risks from their extraordinary support for the economy, including the possibility that it might fuel unwanted inflation or stoke asset bubbles. But in testimony on the central bank's semi-annual report on monetary policy, he said the risks did not seem material at the moment, adding that the central bank has all the tools it needs to retreat from its monetary support in a timely fashion. "We do not see the potential costs of the increased risk-taking in some financial markets as outweighing the benefits of promoting a stronger economic recovery and more rapid job creation," Bernanke told the Senate Banking Committee. The Fed chairman also urged lawmakers to avoid sharp spending cuts set to take effect on Friday, warning that they could combine with earlier tax increases to create a "significant headwind" for the modest economic recovery. In response to the financial crisis and deep recession of 2007-2009, the Fed not only slashed official interest rates effectively to zero, but also bought more than $2.5 trillion in mortgage and Treasury debt in an effort to push down long-term interest rates and spur hiring. The Fed is currently buying $85 billion in bonds each month and has said it plans to keep purchasing assets until it sees a substantial improvement in the outlook for the labor market. Minutes of the Fed's Jan. 29-30 policy meeting, released last week, said a number of officials felt the potential risks posed by the bond purchases could warrant tapering off or ending them before hiring picks up, comments that sparked a sharp stock market sell-off. However, several others argued there was a danger in halting them prematurely. Bernanke appeared to be in the latter camp. "The benefits of asset purchases, and of policy accommodation more generally, are clear," he said, citing improvements in the housing and auto sectors. "There is no risk-free approach to this situation," he said. "The risk of not doing anything is severe as well. So, we are trying to balance these things as best we can." NO SHIFT IN POLICY COURSE Bernanke's testimony and stronger-than-expected data on housing and consumer confidence helped settle jitters in U.S. stock markets over Europe's debt crisis, with the Dow Jones industrial average closing up nearly 116 points, or 0.8 percent. "What Bernanke is saying, bottom line, indicates that there will not be a reversal anytime soon in the stimulus program," said Peter Cardillo, chief market economist at Rockwell Global Capital in New York. When asked pointedly by Republican Senator Bob Corker about whether the Fed's easy policies were contributing to competitive currency devaluations globally and laying the groundwork for inflation, Bernanke was unequivocal. "My inflation record is the best of any Federal Reserve chairman in the post-war period," he retorted. "We are not engaged in a currency war." Democrats, for their part, seized on Bernanke's remarks to fuel their argument that looming budget cuts could have a dire economic impact, as they sought to gain political advantage over Republicans, who prefer spending cuts over higher taxes. Committee newcomer Elizabeth Warren, a Democrat, pressed Bernanke on what she said is an implicit subsidy that large banks enjoy in the form of lower borrowing costs from being perceived as too big to fail. Bernanke countered that Dodd-Frank financial reform rules had given regulators more power to wind down failing financial institutions, making the issue less of a concern. "The subsidy is coming because of market expectations that the government would bail out these firms if they fail. Those expectations are incorrect," Bernanke said. A PLEA ON BUDGET CUTS In unusually direct remarks on fiscal policy, Bernanke warned that the spending cuts known as the sequester that are set to take hold later this week would threaten an already challenged economic expansion. "The Congress and the administration should consider replacing the sharp, frontloaded spending cuts required by the sequestration, with policies that reduce the federal deficit more gradually in the near term but more substantially in the longer run," Bernanke said. The U.S. economy braked sharply in the fourth quarter, but is forecast to grow around 2 percent or more this year. The unemployment rate has remained elevated, and registered 7.9 percent in January. Bernanke, who appears for a second day of testimony before a House of Representatives panel on Wednesday, said persistent joblessness was a scourge with potentially long-lasting effects. "High unemployment has substantial costs, including not only the hardship faced by the unemployed and their families, but also the harm done to the vitality and productive potential of our economy as a whole," Bernanke said.