U.S. interest rate policy is "nearing a crossroads" now that worst-case scenarios for growth have been skirted by the Federal Reserve's aggressive string of rate cuts, San Francisco Fed President Janet Yellen said Monday.
I am somewhat reassured by the recent data, which suggest that my biggest fears on the downside have, so far, been avoided," Yellen said in a speech at the University of California San Diego.
By contrast, "inflation has become an increasing concern," she said, adding that headline inflation is likely to run much higher than desired for the next few quarters, and core prices were also set to rise as businesses pass on higher costs.
Both measures should moderate in 2009 on the back of "slack" in the labor market and a probable leveling off in oil and food prices, she said.
Yellen said there is no sign so far of generalized wage pressure, and that inflation expectations are "reasonably well anchored," but that the Fed was alert to rising risks of inflation.
"The risks to inflation are likely not symmetric and they have definitely increased. We cannot and will not allow a wage-price spiral to develop," she said.
Yellen is not a voting member this year of the U.S. central bank's Federal Open Market Committee, which sets monetary policy.
Double, Double, Toil and Trouble
Problems in the housing and financial markets and soaring commodity prices have equated for the U.S. economy to the three witches of Shakespeare's Macbeth, "brewing up trouble amid thunder and lightning," Yellen said.
The economy was likely to grow "only modestly" for the balance of 2008 before picking up in the new year, helped by the lagged effect of the Fed's spate of interest rate cuts.
The FOMC has lowered its benchmark rate to the current 2 percent from 5.25 percent since late September.
"These cuts in the target rate, along with the actions to foster greater liquidity in financial markets, have mitigated the worst effects of the squeeze on spending," she said.
At this point financial markets expect the rate to be held steady in August but are pricing an increase by October as policy-makers act to tamp down inflation.
Yellen did not signal the timing of the Fed's possible next move, but said that "readiness is all" and that the central bank was "prepared to act as needed."
Consumer spending has been "surprisingly robust," helped in part by billions of dollars in tax rebates being mailed out, she said. "However, a few months of data don't make a trend."
Home prices and construction spending seem likely to continue to fall well into 2009, Yellen said.