WASHINGTON (Reuters) - A weakening housing market, strained banking system and rising oil prices threaten the U.S. economy, and restoring financial market stability is a top priority, Federal Reserve Chairman Ben Bernanke said on Tuesday.

Bernanke, in his semi-annual testimony on economic conditions to lawmakers on Tuesday, acknowledged that financial markets had grown increasingly anxious in recent weeks, particularly over the financial condition of mortgage finance companies Fannie Mae and Freddie Mac.

He stressed that the outlook for economic growth and inflation was unusually uncertain. Investors took that as a signal that the Fed would keep interest rates unchanged at least through August, and perhaps through the end of the year.

"The possibility of higher energy prices, tighter credit conditions, and a still-deeper contraction in housing markets all represent significant downside risks to the outlook for growth. At the same time, upside risks to the inflation outlook have intensified lately," he said.

Bernanke said the slumping housing market was "the most critical and central issue that we face," because it held the key to consumer spending as well as banks' financial health.

His comments come just two days after the Treasury Department, in close coordination with the central bank, announced measures to aid Fannie and Freddie, which have been under pressure as the housing market has deteriorated.

Treasury Secretary Henry Paulson, in prepared testimony, said the government-sponsored enterprises "have the potential to pose a systemic risk" to the financial system, and urged Congress to pass legislation creating a stronger regulator.

Paulson, Bernanke, and Securities and Exchange Commission Chairman Christopher Cox are due to testify before the Senate Banking Committee later on Tuesday about Fannie and Freddie.

WIDE NET

Bernanke's comments offered little comfort to investors. U.S. stock prices fell, although they clawed back some of those losses by late-morning as oil prices dropped. The dollar weakened and U.S. Treasury debt prices rose as a safe-haven alternative to riskier assets.

In its semi-annual monetary policy report to Congress, the Fed raised its projection for growth in 2008 to a range of 1 percent to 1.6 percent from the 0.3 percent to 1.2 percent range it forecast in April, on expectations of stronger consumer spending.

President George W. Bush said the economy was still growing, although he acknowledged "obvious financial uncertainty."

With energy costs rising, the Fed also raised its inflation forecast to a range of 3.8 percent to 4.2 percent, up substantially from its previous 3.1 percent to 3.4 percent projection.

"The net is now extremely wide for the Fed, with upside inflation pressures and considerable downside growth risks," said Dustin Reid, senior currency strategist with ABN AMRO in Chicago. "The Fed's having a difficult time, as are most other central banks, as to what the next (interest rate) move should be."

TIGHT SPOT

Sluggish economic growth and stubborn inflation have put Bernanke in a tight spot as he tries to keep a lid on pricing pressures without tipping the economy into a deep recession.

The usual policy prescription of hiking rates to curb the acceleration in prices, largely coming from costlier energy, might dampen an already slow pace of economic activity.

Pressure has grown -- both inside his policy-making committee and out -- for the Fed to consider raising interest rates after cutting them by 3.25 percentage points to 2 percent since mid-September.

Shortly before Bernanke testified, government reports underlined the dilemma. Sales at retail stores barely edged up in June but producer prices, which reflect wholesale inflation, jumped a larger-than-expected 1.8 percent.

News from the corporate arena was no more reassuring. General Motors Corp, struggling with declining vehicle sales, said it will cut 20 percent of its salaried work force, while Kimberly-Clark Corp cut its profit outlook because of high energy costs.

Bernanke said the Fed's efforts to date, including the rate cuts and a series of new lending facilities, had positive effects but the economy still faced "numerous difficulties."

"Many financial markets and institutions remain under considerable stress, in part because the outlook for the economy, and thus for credit quality, remains uncertain," he said.

"Helping the financial markets to return to more normal functioning will continue to be a top priority of the Federal Reserve," he added.

(Additional reporting by Steven C. Johnson in New York and David Lawder in Washington; Editing by Chizu Nomiyama)