The U.S. economy is on track for sustainable above-trend growth, and with monetary policy still accommodative, interest rates will keep rising, San Francisco Federal Reserve Bank President Janet Yellen said on Friday.
"Over time, the degree of accommodation will have to diminish, with policy reverting toward so-called 'neutral' for inflation to remain well contained," Yellen said. "The Fed is totally committed to price stability."
Separately, Fed Gov. Ben Bernanke said he could not gauge the chances for the central bank adopting a numerical target for inflation, currently a hot topic as it prepares for a leadership change in early 2006.
Yellen and Bernanke, who both spoke at a Stanford Institute of Economic Policy Research conference, were the final Fed officials to take the podium before Chairman Alan Greenspan delivers eagerly awaited testimony on the U.S. economy to Congress next week.
Yellen, who is not a voting member of the Federal Open Market Committee this year, signaled the Fed would continue to push up benchmark rates as it has done since June.
However, the task of deciding how much higher to raise rates is getting trickier, she said.
"The closer the actual rate gets to the neutral range, the more carefully we will need to consider each successive increase" by monitoring how economic activity and inflation develop, Yellen said.
The bank would face "more difficult choices" if output growth and inflation moved in opposite directions, she said, but for now risks were termed balanced.
'AT LEAST A BIT OF SLACK' IN ECONOMY
Labor markets are gradually improving, but with the January jobless rate at 5.2 percent, the economy still has "at least a bit of slack," which should keep a lid on wage-based inflation, she said.
The U.S. central bank has raised interest rates by a quarter percentage point at each of its past six meetings, removing accommodation at what it has termed a "measured" pace as the economy improves.
Yellen said a neutral Fed funds rate is commonly thought to be between 3 percent and 5 percent. That suggests the U.S. is within two "measured" rate hikes of the low end of that range.
She warned a slowdown in productivity growth could stoke inflation, with trend productivity expansion of 2.5 percent cited as a level to watch. Productivity growth, which ran at what Yellen termed an "astounding" rate in recent years, slowed sharply in the third and fourth quarters of 2004.
"The predominant medium-term effect of a slowdown in productivity growth would likely be higher inflation," Yellen said.
INFLATION TARGETING IN POST-GREENSPAN ERA?
Earlier, Bernanke said prospects for the central bank setting an inflation target "depend on how things evolve, obviously, at the Federal Reserve."
The FOMC was set to discuss the merits of an articulated inflation objective at its meeting last week, but mostly to thrash out an idea that has been out of favor during the long Greenspan era, which will end in early 2006.
"What I've tried to do is try to raise the level of the debate, try to get people to look at the issue and talk about it seriously," said Bernanke, a long-time targeting advocate.
Yellen gave qualified support to targets, noting "some benefits" from setting a specific inflation goal but worrying that policy-making could become too rigid.
"It could lead to a loss of focus on the dual goals the Fed has" of promoting price stability and maximum sustainable employment, Yellen told reporters after her speech.
A potential target would be 1.5 percent on the core personal consumption expenditures (PCE) index, within a range of about a point or so, which would equate to about 2 percent in the core consumer price index, she said.
On Thursday, Minneapolis Fed President Gary Stern said inflation targeting was a "valuable idea," following a paper he coauthored in late 2004 advocating the concept.
Bernanke said optimal U.S. inflation would be a 1 percent to 2 percent annual rise in the core PCE, which excludes food and energy costs. (Additional reporting by Andrea Ricci in New York and Tim Ahmann in Washington).