Janet Yellen says Fed misjudged inflation, will continue raising interest rates

CLEVELAND, Ohio - Federal Reserve Chairwoman Janet Yellen said Tuesday that inflation projections might have been incorrect, but the Fed shouldn't wait to make gradual increases in the interest rate.

"My colleagues and I may have misjudged the strength of the labor market, the degree to which longer-run inflation expectations are consistent with our inflation objective, or even the fundamental forces driving inflation," Yellen said during a speech to the National Association for Business Economics at the Hilton in Cleveland.

Economic models failed to predict the targeted 2 percent inflation rate, Yellen said.

"Although we judge that inflation will most likely stabilize around 2 percent over the next few years, the odds that it could turn out to be noticeably different are considerable," Yellen said.

Despite the miscalculations, Yellen said waiting to institute interest rate hikes until reaching the 2 percent benchmark could be a mistake.

"In my view, it strengthens the case for a gradual pace of adjustments," Yellen said. "Moving too quickly risks overadjusting policy to head off projected developments that may not come to pass."

The Fed increased its benchmark lending rate twice in March and June, leaving it at a still-low range of 1 percent to 1.25 percent.

Another increase could come as soon as December.

Key quotes:

  • "An analysis of the pattern of wage growth at the U.S. state level also suggests that subdued growth for the country as a whole probably reflects sluggish productivity or some other factor common to all states, because cross-state differences in wage growth are about what one would expect given cross-state differences in unemployment rates."
  • "Another risk is that our framework for understanding inflation dynamics could be misspecified in some fundamental way, perhaps because our econometric models overlook some factor that will restrain inflation in coming years despite solid labor market conditions. One possibility in this vein is a continuation of the subdued growth in health-care prices that we have seen in recent years--a sector-specific factor not controlled for in standard models. Because health care accounts for a large share of total consumer spending, this slow growth has restrained overall inflation materially and may continue to do so for some time."
  • "Job gains continue to run well ahead of the longer-run pace we estimate would be sufficient, on average, to provide jobs for new entrants to the labor force. Thus, without further modest increases in the federal funds rate over time, there is a risk that the labor market could eventually become overheated, potentially creating an inflationary problem down the road that might be difficult to overcome without triggering a recession. Persistently easy monetary policy might also eventually lead to increased leverage and other developments, with adverse implications for financial stability. For these reasons, and given that monetary policy affects economic activity and inflation with a substantial lag, it would be imprudent to keep monetary policy on hold until inflation is back to 2 percent."
  • "Finally, I would note the possibility that inflation may rise more sharply in response to robust labor market conditions than anticipated. The influence of labor utilization on inflation has become quite modest over the past 20 years, implying that the inflationary consequences of misjudging the sustainable rate of unemployment are low. But we cannot be sure that this modest sensitivity will persist in the face of strong labor market conditions, given that we do not fully understand how it came to be so modest in the first place. Although the evidence is weak that inflation responds in a nonlinear manner to resource utilization, this risk is one that we cannot entirely dismiss."

The Associated Press contributed to this report.

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