Fed's Janet Yellen: Not sure we can do negative rate; rate cut unlikely

As whispers mount that the Fed could implement negative interest rates as a way to goose economic activity, Chair Janet Yellen said Wednesday the central bank has not completely researched whether that would be legal.

During her semiannual congressional testimony, Yellen said the Federal Open Market Committee discussed charging banks to hold excess reserves at the Fed but never fully researched the issue.

"We didn't fully look at the legal issues around that," she said. "I would say that remains a question that we still would need to investigate more thoroughly."

Asked whether she foresees the Fed cutting rates after just hiking its interest rate target in December, Yellen said she did not expect that to happen anytime soon as she considers the risk of recession low.

"There would seem to be increased fears of recession risks that is resulting in rising in risk premia. We've not yet seen a sharp drop-off in growth, either globally or in the United States, but we certainly recognize that global market developments bear close watching," she told the House Financial Services Committee.

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Her testimony comes as speculation grows that the Fed might consider implementing negative rates on what it pays on excess reserves. That would be one option the Fed would have should the current bout of economic softness intensify.

"I do not expect the FOMC is going to be soon in the situation where it's necessary to cut rates," she said. "Let's not forget, the labor market is continuing to perform well, to improve. I continue to think many of the factors holding down inflation are transitory. ... We want to be careful not to jump to a premature conclusion about what's in store for the U.S. economy."

In the 2010 examination of whether to use negative rates, Yellen said that outside of the legal questions, there was doubt raised over whether it was the right way to go.

"We got only to the point of thinking it wasn't a preferred tool," she said. "We were concerned about the impact it would have on money markets, we were worried it wouldn't work in our institutional environment."

During the question and answer session, she added that the Fed wouldn't be bound by set benchmarks or guidelines such as the Taylor rule that prescribes rates depending on economic milestones.

"The benefit of a rule-based system is it's systematic and understandable," Yellen said. However, she said her fellow Fed officials believe the rules constitute only a "useful benchmark" but that "we need to take into account a large set of indicators of how the economy is performing."

The Fed hiked its rate target a quarter-point in December after keeping the funds level near zero since late-2008. Zero interest rate policy coincided with a monthly bond-buying program known as quantitative easing, three rounds of each exploded the Fed's balance sheet to $4.5 trillion.

Tightening financial conditions driven by falling stock prices, uncertainty over China and a global reassessment of credit risk could throw the U.S. economy off track from an otherwise solid course, Yellen said earlier in prepared testimony to Congress.

In testimony that combined a steady-as-she-goes account of Fed policy with an acknowledgement of intensifying risks, Yellen said there are good reasons to believe the U.S. will stay on a path of moderate growth that will allow the Fed to pursue "gradual" adjustments to monetary policy.

In her remarks, Yellen said that more than seven years after the emergency policies were put in place, family incomes and wealth are rising, domestic spending "has continued to advance," and business investment outside the oil sector accelerated in the second half of the year. She said she expects the labor market to continue to improve and inflation eventually rise toward the Fed's target despite a recent drop in inflation expectations cited by some policymakers as particularly unnerving.

The unemployment rate in January fell to 4.9 percent, though a more encompassing rate that includes those not looking for work or at part-time jobs for economic reasons remained at 9.9 percent. Despite the improvement in labor conditions, Wall Street economists have been ratcheting down economic growth projections for 2016, though few expect a recession to take hold.

Yellen said some of the weaknesses in the global economy have become self re-enforcing, with weak growth in major manufacturers like China and oversupply on commodity markets rattling the world's oil and mineral exporters. A broad sense of a world slowdown, in turn, and uncertainty about the depth of China's problems, has tightened financial conditions for U.S. businesses.

"These developments if they prove persistent, could weigh on the outlook for economic activity and the labor market," Yellen said in her prepared remarks.

An accompanying report said the U.S. financial sector "has been resilient" to stress from oil and weakening corporate debt markets around the world, with "limited" exposure among large U.S. banks. But "if conditions in these sectors worsen ... wider stresses could emerge."

Yellen singled out uncertainty over recent changes in China's currency policy and the prospects for its economy as a particular culprit behind recent financial market volatility, with the potential to drag down other countries dependent on commodity and other exports to China.

"Should any of these downside risks materialize, foreign activity and demand for U.S. exports could weaken and financial markets could tighten further," she said.

—Reuters contributed to this report.