CLEVELAND – Federal Reserve Chair Janet Yellen acknowledged Tuesday that the Fed is puzzled by the persistence of unusually low inflation and that it might have to adjust the timing of its interest rate policies accordingly.
Speaking to a conference of economists, Yellen touched upon key questions the Fed is confronting as it tries to determine why inflation has remained chronically below its inflation target of 2 percent annually. The Fed chair said officials still expect the forces keeping inflation low to fade eventually. But she conceded that the Fed may need to adjust its assumptions.
Most analysts expect the central bank to raise rates in December, for a third time this year, in a reflection of the economy’s improvement. But the Fed has said its rate hikes will depend on incoming data.
In her speech in Cleveland to the annual conference of the National Association for Business Economics, Yellen went further than she has before in suggesting that the Fed could be mistaken in the assumptions it is making about inflation.
“My colleagues and I may have misjudged the strength of the labor market, the degree to which longer-run inflation expectations are consistent with our inflation objective or even the fundamental forces driving inflation,” Yellen said.
The Fed seeks to control interest rates to promote maximum employment and stable prices, which it defines as annual price increases of 2 percent. While the Fed has met its goal on employment, with the jobless rate at 4.4 percent, near a 16-year low, it has continued to miss its inflation target.
Chronically low inflation can depress economic growth because consumers typically delay purchases when they think prices will stay the same or even decline.
Inflation, which was nearing the 2 percent goal at the start of the year, has since then fallen further behind and is now rising at an annual rate of just 1.4 percent.
Yellen has previously attributed the miss on inflation this year to temporary factors, including a price war among mobile phone companies. She and other Fed officials have predicted that inflation would soon begin rising toward the Fed’s 2 percent inflation target, helped by tight labor markets that will drive up wage gains.
In her remarks Tuesday, Yellen said this outcome of a rebound in inflation is still likely. But she said the central bank needed to remain alert to the possibility that other forces not clearly understood might continue to keep inflation lower than the Fed’s 2 percent goal.
She said in the face of “significant uncertainties,” she believed the Fed’s best course was to move gradually in adjusting its benchmark interest rate. Yellen said that the Fed needed to balance the risk of raising rates too quickly against the risk of raising rates too slowly.
The Fed chair said that if the central bank moved too slowly, it could inadvertently allow the economy to become overheated and thus have to raise rates so quickly in the future that it could push the country into a recession.
“It would be imprudent to keep monetary policy on hold until inflation is back to 2 percent,” Yellen said.
Yellen’s remarks came a week after Fed officials left their benchmark rate unchanged but announced that they would start gradually shrinking their huge portfolio of Treasury and mortgage bonds. Those holdings had grown from purchases the Fed made over the past nine years to try to lower long-term borrowing rates and help the U.S. economy recover from the worst downturn since the 1930s.
The Fed did retain a forecast showing that officials expect to boost rates three times this year. So far, they have increased their benchmark lending rate twice, in March and June, leaving it at a still-low range of 1 percent to 1.25 percent.
Last week, the Fed said the reductions in its bond holdings would begin in October by initially allowing a modest $10 billion in maturing bonds to roll off the $4.5 trillion balance sheet each month.
The size of the monthly reductions will be increased by $10 billion each quarter until they reach $50 billion a month a year from now. The balance sheet is expected to remain just under $3 trillion two years from now, still far higher than the $900 billion level in effect before the financial crisis erupted in 2008.
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