Using words like “sluggish” and “deteriorated,” Federal Reserve Chairman Ben Bernanke gave a starkly pessimistic assessment of the nation’s economy on Thursday and signaled that the Fed will cut interest rates further if needed to combat the adverse effects of a prolonged housing slump and a severe credit crisis.

Both Bernanke and Treasury Secretary Henry Paulson told a congressional hearing that the economy could still avert a full-blown recession, but Democrats said they believed the government should be doing much more to help millions of Americans cope with a threatened tidal wave of mortgage foreclosures.

Bernanke told the Senate Banking Committee that the serious housing slump and a credit crisis triggered by rising defaults in subprime mortgages had greatly strained the economy.

“The outlook for the economy has worsened in recent months, and the downside risks to growth have increased,” Bernanke told the committee. “To date, the largest economic effects of the financial turmoil appear to have been on the housing market, which, as you know, has deteriorated significantly over the past two years or so.”

Bernanke noted that hiring has slowed, with job creation falling by 17,000 in January, the first such setback in more than four years. He said the weaker labor market, along with recent declines in stock prices and declining home prices, were likely to be a drag on consumer confidence going forward.

The Fed chief told senators that the “virtual shutdown” of the market for subprime mortgages given to people with blemished credit histories or low incomes — and a reluctance by skittish lenders to make “jumbo” home loans exceeding $417,000 — have aggravated problems in the housing market. “Further cuts in homebuilding and in related activities are likely,” he said.

Bernanke said that in his own economic forecast he did not predict a recession but a period of sluggish growth “followed by a somewhat stronger pace of growth starting later this year” as the impacts of the Fed’s rate cuts and the $168 billion economic stimulus package of tax rebates begin to be felt.

However, he also said there were significant downside risks, ranging from the threat that the housing slide could become even more severe, the job market could deteriorate more than currently expected or the credit squeeze will intensify. He said the Fed would be monitoring the economy closely and would “act in a timely manner as needed to support growth and provide adequate insurance against downside risks.”

On Wall Street, Bernanke’s comments pushed stocks lower. The Dow Jones industrials closed down 175.26 points at 12,376.98.