The Federal Reserve may have overstated the strength of the labor market and the rate of inflation, which could lead to monetary policy ahead that will be easier than previously thought, Fed Chair Janet Yellen said Tuesday.
In a speech delivered to the National Association for Business Economics in Cleveland, Yellen admitted that trends in employment and wage and price pressures have shifted from what central bank forecasters expected.
The result would be an even more dovish Fed when it comes to removing the historically aggressive policy accommodation in place since the financial crisis.
"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, according to prepared remarks.
The speech comes less than a week after the policymaking Federal Open Market Committee approved the first steps in unwinding some of the stimulus the Fed has provided since late-2008. The central bank will begin rolling off some of the bonds it holds on its $4.5 trillion balance sheet.
In addition, the FOMC has been slowly raising rates, though it chose not to do so at the September meeting.
The committee lowered its expectations for inflation ahead and said its longer-run benchmark interest rate is probably a quarter point below earlier projections.
Yellen said a regular pace of rate hikes ahead is likely still warranted, though Fed officials are looking closely at the assumptions underlying those projections. While conceding that the Fed may need to slow the removal of accommodation, she also said the central bank "should also be wary of moving too gradually."
Addressing current economic conditions, Yellen said the Fed still expects longer-run inflation to trend toward the 2 percent target policymakers believe is healthy for economic growth. However, she said they are making room for the possibility that they're wrong.
"How should policy be formulated in the face of such significant uncertainties?" she said. "In my view, it strengthens the case for a gradual pace of adjustments. Moving too quickly risks overadjusting policy to head off projected developments that may not come to pass."
While lower inflation and interest rates sound beneficial, Fed officials worry that keeping rates lower allows little room for stimulus when another economic slowdown hits. Yellen's comments reflected those from a paper released this week from the San Francisco Fed, where economists worried that a lower "neutral rate," or that which keeps the economy in equilibrium, also limits the monetary policy options.
"Sustained low inflation such as this is undesirable because, among other things, it generally leads to low settings of the federal funds rate in normal times, thereby providing less scope to ease monetary policy to fight recessions," Yellen said.
She said "key assumptions" making up the Fed's baseline forecasts "could be wrong." Yellen attributed the inaccuracies to a prolonged productivity slowdown, reduced inflation expectations and other dynamics that have restrained growth and inflation.