NEW YORK (Reuters) - The dollar retreated on Thursday after Federal Reserve Chairman Ben Bernanke told a congressional committee that more interest rate cuts may be necessary because the U.S. economic outlook has worsened.

A worker inspects U.S. dollar bills inside a money changer in Manila October 26, 2006. REUTERS/Romeo Ranoco

Sharp losses in U.S. shares have also weighed on dollar/yen after worse-than-expected results from brokerage Merrill Lynch MER.N reignited investors' aversion to risk.

Bernanke’s bleak assessment of the U.S. economy’s health in testimony before the House of Representatives’ Budget Committee further added to the gloom in the market.

The Fed chief’s comments were widely seen as a signal that the U.S. central bank would slash rates by a hefty half-percentage point at month’s end, which would undermine the attractiveness of dollar-denominated assets.

Separately, a survey showed factory activity in the U.S. Mid-Atlantic region contracted dramatically in January, reinforcing fears of recession.

“Overall, the testimony reinforced the view that the Fed is more concerned about downside risks to growth than upside risks to inflation at this stage, and appears to favor maximum monetary and fiscal stimulus in the first half to head off the risk of recession,” said Michael Woolfolk, senior currency strategist, at Bank of New York Mellon.

Late afternoon in New York, the dollar was down 0.7 percent against the yen at 106.74, though it was well off the session low at 106.61. Against a basket of major currencies, the dollar slipped 0.1 percent to 76.190 .DXY.

The euro hit a session low of 156.34 yen, down nearly 0.8 percent from late on Wednesday.

Bernanke also told lawmakers that he does not expect the United States to slide into a recession, although that provided little relief to the markets.

“The U.S. economy remains extraordinarily resilient,” he said. “We currently see the economy as continuing to grow but growing at a relatively slow pace, particularly in the first half of this year.”

Also on Thursday, the Philadelphia Federal Reserve Bank said its business activity index plunged to minus 20.9 in January from minus 1.6 in December, putting further pressure on the dollar.

It was the sharpest one-month drop since January 2001, as the economy was on the cusp of a recession, and well below economists’ forecasts for a slight uptick to minus 1.0.

“Because the index has proven to be a helpful bellwether of broader, national indicators of manufacturing activity, this sharp drop is an especially worrisome sign that the economy may be sliding into contraction or may already be in decline,” said David Resler, chief economist at security firm Nomura in New York.

The euro was little changed at $1.4656. The single currency was earlier bolstered by comments from European Central Bank President Jean-Claude Trichet on Thursday. He said efforts to anchor inflation should lead to high levels of growth in the euro zone.

Elsewhere, sterling rose against the euro and dollar after John Gieve, deputy governor of the Bank of England, said inflation is likely to rise well above target in the coming months.

The British currency has come under pressure in recent weeks as weak data led to increased expectations of a UK rate cut. But Gieve’s comments shifted investors’ focus to inflation that could limit the extent of interest rate cuts.

Sterling was last up 0.3 percent against the dollar at $1.9695 GBP=. Euro/sterling was down 0.4 percent at 74.39 pence.