Fed's Yellen: Jobless jump shows economy's risks

By Ros Krasny

LOS ANGELES (Reuters) - San Francisco Federal Reserve Bank President Janet Yellen said on Friday that an unexpected jump in the August unemployment rate highlights the risk of a vicious cycle of weakness locking into place for the U.S. economy.

Yellen's comments to the Rotary Club of Los Angeles were similar to those made in Salt Lake City on Thursday.

Since then, though, the Labor Department announced on Friday the August jobless rate at 6.1 percent, far above the July level of 5.7 percent.

Yellen said the U.S. economy could face "a deepening of the adverse feedback loop" that she has been warning of for most of 2008: more joblessness causing more mortgage defaults, tighter credit conditions and further downward pressure on activity and employment.

"This kind of process represents a downside risk for the economy, and today's jump in the unemployment rate highlights that risk," she said.

At 6.1 percent, joblessness is more than a full percentage point over "full employment," or the rate below which inflation pressures tend to build, Yellen added.

Yellen said the current federal funds rate of 2 percent, while low by historical standards, is not "excessively stimulatory" because financial conditions are more restrictive now than they were a year ago.

"Policy must be calibrated to push through the substantial headwinds the economy faces," she said.

As well as a gloomy economic outlook, Yellen focused on much-improved prospects for inflation

"Inflation risks have diminished somewhat in recent months as commodity prices have come down from their highs," Yellen said. "I am very hopeful that inflation will come down quite substantially, though perhaps not as fast as I'd like."

Inflation could start to fall after another quarter or two, she said.

Yellen is not a voting member of the central bank's Federal Open Market Committee in 2008. She will vote in 2009.

Financial markets on Friday started to price a slight chance that the Fed will lower its benchmark fed funds rate to 1.75 percent from 2 percent by year-end after the surprisingly weak August payrolls report from the Labor Department.

Speaking to reporters on Thursday, Yellen had envisaged a scenario that could force the Fed to lower rates again, even though she said that an eventual rate increase was still the more likely outcome.

Among the issues facing the economy, Yellen said, were problems in financial markets that "are ongoing and perhaps deepening" as banks and other financial firms scale back their balance sheets and shrink their lending.