Fed's Yellen: Weak Infl Temporary; Gradual Hikes Appropriate

--Hiking Too Slowly Risks Overheating Labor Market

--Expect Inflation to Rise as Labor Market Strengthens

--Significant Uncertainties Facing Inflation Outlook

By Jean Yung

     WASHINGTON (MNI) - A midyear shortfall in inflation is "probably temporary"

though considerable uncertainty over the outlook for inflation strengthens the

case for the Federal Reserve to tighten monetary policy in a not-too-fast and

not-too-slow manner, Chair Janet Yellen said Tuesday as she laid out an in-depth

analysis of the central bank's inflation model. 

     "How should policy be formulated in the face of such significant

uncertainties? In my view, it strengthens the case for a gradual pace of

adjustments," Yellen said in remarks prepared for a conference in Cleveland. 

     "A gradual approach is particularly appropriate in light of subdued

inflation and a low neutral real interest rate, which imply that the FOMC will

have only limited scope to cut the federal funds rate should the economy be hit

with an adverse shock," she said. 

     "But we should also be wary of moving too gradually" as there is a risk

that the labor market could eventually become overheated, potentially creating

an inflationary problem down the road that might be difficult to overcome

without triggering a recession." 

     Yellen said she and her colleagues on the Federal Open Market Committee

"currently think that this year's low inflation is probably temporary," and

continue to anticipate the inflation will stabilize around 2% over the next few

years. 

     However, this conclusion is based on some key assumptions that "could be

wrong in ways that imply that inflation will remain low for longer than

currently projected." These include: labor market conditions may not be as tight

as they appear; long-run inflation expectations may not be as well anchored at

2% as policymakers believe; and finally that the Fed's framework for

understanding inflation could be "misspecified in some fundamental way," Yellen

said. 

     Yellen reiterated that she believe the factors that have held down

inflation "should fade over time." Some of the recent decline in inflation

"reflects idiosyncratic shifts in the prices of some items," including a one-off

drop in wireless service prices. 

     Some analysts have pointed to sluggish wage growth as evidence that the

labor market has not returned to full strength, Yellen said, but some analysis

suggests that "subdued growth for the country as a whole probably reflects

sluggish productivity or some other factor common to all states." 

     She also noted that surveys indicate more firms are planning wage increases

and have difficulties finding qualified workers -- "possible harbingers of

stronger wage gains to come."

     She warned that it is possible inflation "may rise more sharply in response

to robust labor market conditions than anticipated." Just as economists are not

sure why the Phillips Curve has become so flat over the past two decades, they

cannot be sure that it will stay flat in the face of strong labor market

conditions. 

     "Overall, I view the data we have in hand as suggesting a generally healthy

labor market, not one in which substantial slack remains or one that is

overheated," the Fed chair said. 

     Turning to inflation expectations, Yellen conceded that there is some

evidence that expectations "may have slipped a bit over the past two or three

years" and if that were the case, then "stabilizing inflation at around 2

percent could prove to be more difficult than expected." 

     However, the FOMC currently believes inflation expectations overall will be

reasonably well anchored at 2%. 

     Yellen finally discussed the possibility that supply side shocks or global

factors could have lasting impact on U.S. inflation but drew no strong

conclusions. 

     She repeated the FOMC is committed to its inflation goal and will keep an

open mind on the best monetary policy necessary to fulfill its mandate.   

--MNI Washington Bureau; +1 202-371-2121; email: jean.yung@marketnews.com

[TOPICS: MMUFE$,M$U$$$]