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UPDATE 1-Fed's Yellen says gradual hikes should continue, despite weak inflation

inflation@ (Adds more from speech, analysts comment, market reaction)

CLEVELAND, Sept 26 (Reuters) - The Federal Reserve needs to continue gradual rate hikes despite broad uncertainty about the path of inflation, Fed Chair Janet Yellen said on Tuesday in remarks that acknowledged the central bank's struggles to forecast one of its key policy objectives.

It is possible, Yellen said, that the Fed may have "misspecified" its models for inflation, and "misjudged" key facts like the underlying strength of the labor market and whether inflation expectations are as stable as they seem. While there is not enough evidence of a major shift in inflation dynamics for the Fed to yet pull back from its plan to gradually raise rates, she said the central bank needed to remain open to that possibility. Recent low inflation "likely reflects factors whose influence should fade over time," Yellen said in a 37-page address to the National Association for Business Economics.

Despite "many uncertainties" around how inflation is behaving, Yellen said it nevertheless "would be imprudent to keep monetary policy on hold until inflation is back to 2 percent."

"Without further modest increases in the federal funds rate over time, 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," she said.

Yellen's remarks attempt to resolve a debate that has split members of the central bank among those worried that inflation may be permanently anchored below the Fed's 2 percent target because of structural changes in the global economy, and those who feel it is only a matter of time before tight labor markets lead wages and prices to rise.

She did not provide a definite answer, pointing to the fact that in current forecasts there was a 30 percent chance inflation could range anywhere from one percent to 3 percent, vastly different outcomes either of which could rewrite the Feds policy approach. But she did make clear that, as a matter of managing risks, the Fed still feels a gradual pace of rate hikes remains the base case.

Kevin Logan, chief U.S. economist at HSBC Securities, in New York, said her message is that theyre not really sure whether the weak inflation is transitory but that nonetheless policy is accommodative.

The gradual approach means that, even if they are wrong on inflation it wont be a big mistake. Thats the message they are trying to convey.

The dollar first shot up then retreated after Yellen's comments, reflecting uncertainty about her message. Treasury yields and stocks edged slightly higher.

INFLATION DEBATE

Yellen walked systematically through many of the main arguments in favor of a structural change in inflation, and largely discounted them.

There was not yet "empirical support" for the theory that global trade, worldwide supply chains, and other forces were holding down U.S. prices, she said.

Fed calculations are that cyclical slack in the labor market was now having a "negligible" impact on recent low inflation readings, compared to things like oil price and other changes that will fade over time. And some aspects of the labor market that appeared weak, such as the still-elevated number of part-time workers, may reflect permanent changes in the workforce, and not cyclical factors, Yellen said.

There were many uncertainties, however, and downward pressure on inflation could prove unexpectedly persistent.

"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," possibilities which the Fed needs to examine over time and change the course of policy if needed.

But for now the Fed "continues to anticipate that, with gradual adjustments in the stance of monetary policy, inflation will rise and stabilize at around 2 percent over the medium term," she said. "We should be wary of moving too gradually." (Reporting by Howard Schneider and Ann Saphir; Editing by Andrea Ricci)