Yellen says Fed rate policy nearing crossroads

PORTLAND, Oregon (Reuters) - The Federal Reserve is heading toward a "crossroads" on interest rate policy with inflation rising and growth weak, but the worst risks to the economy seem to have been avoided for now, a top Fed official said on Thursday.

Janet Yellen, president of the San Francisco Fed, said growth is poised to strengthen in 2009, and that with inflation "a concern" hinted that the Fed's next move on interest rates could be an increase, as financial markets now expect.

She also said the Fed's moves to extend its safety net to investment banks lessened the chance of "systemic risk" sweeping financial markets, adding that the Fed would do more if needed.

"We might have seen another Bear Stearns situation" without the Fed's aggressive moves, Yellen told reporters after a speech in Portland, Oregon, referring to the Fed's role in backstopping JPMorgan Chase's purchase of the failing investment bank.

Yellen said it was conceivable that the Fed's primary dealer credit facility, an emergency lending facility established in March to ease constraints in credit markets, could be extended beyond its planned "sunset" in September.

But the Fed's liquidity measures meant a shifting regulatory landscape for financial firms, she said.

"We can't have institutions that have access to the safety net ... operate without some of the same kinds of constraints and supervision" imposed on banks already regulated by the Fed, she said. "We clearly need to figure out the right way to supervise those institutions."

Her remarks came on the same day that Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson testified to Congress about the need to overhaul the financial regulatory system in order to avert future crises.

A TILT TOWARD TIGHTENING?

In discussing the risks of inflation as she hinted that the Fed's next change in interest rates would be a hike, Yellen said, "Inflation is a concern," adding that the Fed is "prepared to act as needed."

Right now, though, "we've got one arm pulled in one direction, one in another direction," she told reporters.

Yellen is not a voting member of the central bank's monetary policy-setting Federal Open Market Committee in 2008, but will vote in 2009.

A string of rate cuts by the Fed from September through April, which cut the benchmark federal funds lending rates to 2 percent from 5.25 percent, helped prevent the worst-case outcome for growth, said Yellen.

"I am somewhat reassured by the recent data, which suggest that my biggest fears on the downside have, so far, been avoided. However, a few months of data don't make a trend."

Financial markets are pricing an FOMC rate increase to 2.25 percent by October, believing that policy-makers will act to tamp down inflation once the economy stabilizes.

Yellen said that although consumer confidence has "cratered," there was less chance now than a few months ago of financial problems, consumer confidence and retail spending developing into a vicious circle that will continue to drag down the economy.

"It's a diminishing risk, but not a nonexistent risk," she said.

Retail spending has held up better than expected, even in advance of billions of dollars in tax rebate checks received by Americans since May, she said.

Spending may have gotten a boost in advance of the checks, Yellen said, adding that "We noticed that Google hits on 'tax rebates' peaked in April."

(Editing by Leslie Adler)