US inflation risks linger, although housing market still weak

CHICAGO - The United States still runs the risk of higher inflation even as growth has slowed, making the current pause in Federal Reserve rate policy a wise choice, San Francisco Fed Bank President Janet Yellen said today.

"Holding the stance of policy steady for a time makes sense to me," said Yellen, a voting member of the Federal Open Market Committee this year. She termed current benchmark interest rates "moderately restrictive."

Still, Yellen said the housing market has weakened more sharply than many policy-makers had expected and the reversal of a housing-related "wealth effect" was a threat to consumer spending.

"The inflation outlook remains highly uncertain, and until we actually see inflation begin to slow down, I will be focused on the upside risks in the outlook," Yellen said in a speech to the California Independent Bankers convention in Laguna Beach, California.

The speech was closed to the press; a copy of Yellen's remarks was made available in advance.

Yellen said she was encouraged that core inflation -- which excludes volatile energy and food prices -- has edged down recently, but "it's clear that more progress is needed."

The Federal Open Market Committee, the Fed's rate-setting body, remains responsive to incoming data and is aware of the lags between its policy actions and their impact on the economy, she said.

"We have yet to see the full effects of the series of 17 funds rate increases -- some are probably still in the pipeline."

Financial markets assess the Fed will keep benchmark rates steady at 5.25 per cent at least through year end, and Yellen seemed to endorse that view. US Treasury debt markets were closed on Monday for the Columbus Day holiday.

The FOMC last raised interest rates in June, its final move, for the time being, in a long string of one-quarter percentage point rate hikes that started in June 2004.

Yellen said the US jobless rate in September, at 4.6 per cent, was "a bit lower than conventional estimates of so-called 'full employment' and therefore suggests that by now labor markets may have moved a bit to the tight side."

Still, assessing the US economy, Yellen said second-half growth is in a "noticeable slowdown" below its trend level.

"If this continues for a time, as I think is likely, the tightness we have seen in labor and product markets would ease somewhat, tending gradually to reverse any underlying inflation pressures," she said.

A big part of the slowdown was tied to the unexpectedly fast, and still ongoing, decline in the residential housing market.

"Frankly, the pace of it has been a little surprising," Yellen said, adding the reversal of the housing-related "wealth effect" could weaken consumer spending growth.

Some housing-industry contacts in the Fed's 12th District, which covers the western United States, are "willing to bet that things will get worse before they get better," Yellen said.

"We have already seen that the pace of house-price appreciation has clearly moderated, and there are signs that it may continue," she said.

That assessment was in contrast with comments from former Fed Chairman Alan Greenspan, who said at an event in Calgary, Canada, on Friday that the "worst may well be over" for the housing market.

Some economists have tied the recent decline in US jobs growth to setbacks in housing-related hiring, although construction jobs continued to rise in September.

If housing is a negative, Yellen said lower energy prices could be a net positive in 2007.

The spending restraint seen recently due to high petrol prices at the pump should evaporate in 2007, she said. "In fact, stable oil prices would actually contribute to a pickup in growth next year."

- REUTERS