Discomfort zone

In a Reuters news item today, by Ros Krasny, Janet Yellen, the SF Fed Governor, allows as how inflation is, and can be expected to remain, above her personal comfort zone. That is bound to provide a bit of discomfort to the folks expecting the Fed "pause" to be followed any time now with a rate cut.

It could take several years for a key measure of inflation to ease from current high levels, and in the meantime the Federal Reserve must be biased toward additional interest rate increases, the head of the San Francisco Fed said on Thursday.

But she said that attempting to drag inflation down "within a year or two" could risk damaging the economy.

She maintains an informal "comfort zone" for inflation of 1 percent to 2 percent on the core personal consumption expenditures (PCE) price index -- often termed the Fed's favorite inflation gauge -- which in the year through July advanced at 2.4 percent.

The Fed was "prudent" in holding benchmark rates steady in August to await more information on how a two-year string of rate increases was affecting the economy on a lagged basis, Yellen said.

Yellen told reporters that while inflation is above the comfort zone, "a mildly restrictive stance would seem to be appropriate" -- comments that could dim hopes in financial markets that the Fed will start trimming rates in early 2007.

"The Fed has to be focused on bringing inflation down," and at 5.25 percent, the current federal funds rate is "modestly, mildly restrictive," Yellen said.

Yellen said the U.S. economy "is still very strong" even though it has entered -- as the Fed anticipated -- a period of "slightly below trend growth."

That unspecified period of slower growth will help reduce pressures on resources within the U.S. economy and should help move core inflation lower "gradually," Yellen said.

Still, Yellen said that wage pressures were troubling her more now than when she last spoke publicly on July 31.

"I must admit I'm also less sanguine than I was a month ago about one particular factor in the inflation process -- namely, labor compensation," she said. "Recently revised information on compensation per hour suggests that wages and benefits are growing rapidly."

Still, even that trend is "blurry" because some wage indicators show much more moderate growth than others, and cyclical wage pressures could in turn start to moderate in line with slower economic growth, Yellen said.

Yellen said the lagged impact of the Fed's two years of rate increases should reduce demand in sectors such as autos, consumer durables and housing.

"We have already seen clear evidence of cooling in the housing sector," Yellen said, adding the effects of the housing slowdown go beyond their direct contribution to gross domestic product growth and that slower increases in house prices could weaken consumer spending in a couple of ways.

The negative U.S. savings rate was "a downside risk to the economy," she noted, with the chance of a sizable drop-off in consumer spending likely to be bigger than a surge in spending.