Fed's Yellen says unwise to allow U.S. economy to run 'hot'

By Ann Saphir

PALO ALTO, Calif. (Reuters) - With monetary policy still modestly accommodative, the U.S. central bank should continue to raise interest rates slowly or risk harm to the recovery the Fed has sought to nurture, Federal Reserve Chair Janet Yellen said on Thursday.

"I think that allowing the economy to run markedly and persistently “hot” would be risky and unwise," Yellen said at the Stanford Institute for Economic Policy Research.

While there are no signs as yet that the Fed is behind the curve or the economy is in danger of a sudden surge in inflation, she said, "I consider it prudent to adjust the stance of monetary policy gradually over time."

The downward pressure that the Fed's $4.5 trillion balance sheet has been exerting on rates for the last several years is declining, she said, making it all the more important to raise rates only gradually.

The Fed last month raised its short-term interest-rate target for only the second time in a decade, but signaled it would likely speed up the pace of rate hikes this year. Rates are currently targeted at between 0.5 percent and 0.75 percent.

With unemployment, at 4.7 percent, near what many economists including Yellen see as its long-run sustainable level, and inflation closing in on the Fed's 2-percent goal, most Fed officials expect to lift rates three times over the course of the next 12 months.

Some left-leaning economists and activists have urged the Fed to keep rates low to provide more opportunities for the jobless and to push up on wages, whose growth has been tepid.

Meanwhile Republican Donald Trump, who is set to become the next U.S. President on Friday, has promised a set of economic policies including tax and regulatory reform aimed at boosting economic growth.

Yellen for the second time in two days warned that a delay in tightening monetary policy could drive up inflation and force the Fed to jack up rates in response, sending the economy into a tailspin that might have been avoided if the rate hikes had been more gradual.

It "will not be easy" to find a path of rate hikes that can foster strong jobs growth and 2-percent inflation, given the uncertainties of global growth, slow domestic productivity growth, and a change in fiscal policies, among others.

The path of rate hikes could differ from current expectations depending on how those uncertainties unfold, she said.

The Fed consults a range of policy rules, including one developed by Stanford Professor John Taylor, to guide its decisions on rates, Yellen said. But those rules cannot be mechanically implemented because they do not take into account the lack of flexibility the Fed has in dealing with shocks when rates are low, nor many other important factors, she said.

In comments to Taylor after the speech, Yellen reiterated her opposition to a proposed law that would require the Fed to follow his namesake policy rule, saying that the threat of an audit should the Fed deviate from it would subject the central bank to short-term political pressures.

(Reporting by Ann Saphir; editing by Diane Craft)