Fed's Yellen looks ahead to rate increases

VANCOUVER, British Columbia (Reuters) - U.S. interest rates have now been cut to the right level to bolster the economy and will need to be raised in a timely fashion as growth picks up, San Francisco Federal Reserve Bank President Janet Yellen said on Tuesday.

"I would be pleased if futures markets turn out to be right" in their call for the Fed to start raising rates late this year, Yellen told reporters after a speech to the CFA Institute conference in Vancouver. "It's too early to make the call on whether December will be the right time."

Derivatives markets on Tuesday almost fully priced in an increase in the benchmark federal funds rate to 2.25 percent from the current 2 percent by the scheduled December meeting of the Fed's policy-setting Federal Open Market Committee.

Yellen, not a voting member of the FOMC in 2008, told reporters a rate hike would be a sign that the economy had picked up, but that further weakness before then would not be a surprise, nor make an automatic case for more rate cuts.

"I consider the current level of monetary accommodation to be appropriate. That, together with the fiscal package, should be sufficient to promote a gradual step up to moderate economic growth later this year," she said.

Estimates on second-quarter growth range widely, with negative growth "possible," Yellen said, on the back of two straight quarters of meager 0.6-percent increases in gross domestic product.

In her speech Yellen noted that the real federal funds rate is "at an accommodative level of around zero," or equal to the rate of inflation.

It will be important for the Fed to not leave economic stimulus in place once the economy turns, she said, adding:

"Recent movements highlight the risk that our attempts to deal with problems in the real economy could lead to higher inflation expectations and an erosion of our credibility."

INFLATION HEADED DOWN?

Yellen said her baseline forecast is that inflation will ease as slow growth builds more slack into labor and product markets.

For now, the economy is pinned down by the "grim trio" of the credit crunch, the housing downturn and high commodity prices, and the jobless rate is likely to rise, she said.

The housing market, in particular, has no quick fix on tap. and was termed the most worrisome element.

"Construction spending and house prices seem likely to continue to decline well into 2009," she said.

Yellen said the tax rebates now on the way to millions of Americans should have a positive impact, with much of the money likely to be spent rather than saved by consumers whose access to credit has been choked off in recent months.

"The main effects of the program are likely to hit in the current and next quarters, and they could be substantial," she said. "Consumers who are liquidity constrained ... tend to spend a lot of the checks when they get them."

At this point there seems no need for a second round of tax rebates, she said.

Turning to inflation, Yellen said there was a risk that commodity prices will not level off, as implied by futures markets, and may continue to stoke inflation.

"If we keep being wrong on commodity prices, that can become a problem for inflation," she said. "And even if the direct influences of commodity prices on inflation eventually dissipate, they could still cause trouble."

But Yellen also said the Fed would guard against stagflation, a dreaded mix of very weak growth and rising prices most recently seen in the 1970s.

Spiraling inflation similar to that seen in the 1970s would be "a nightmare scenario, the worst possible outcome," she said. "I don't think there's anyone sitting around the (FOMC) table who would allow that."

(Editing by James Dalgleish)