Given the numerous uncertainties in the current economy, especially why inflation hasn’t risen, gradual rate hikes remain the best course, Federal Reserve Board Chair Janet Yellen said Tuesday.

“How should policy be formulated in the face of such significant uncertainties? In my view, it strengthens the case for a gradual pace of adjustments,” Yellen said at the National Association for Business Economics annual meeting, according to prepared text released by the Fed.

By raising rates too aggressively, the Fed could overadjust policy, she said, while not tightening enough could lead to the labor market overheating “potentially creating an inflationary problem down the road that might be difficult to overcome without triggering a recession.”

Federal Reserve Chair Janet Yellen.
Federal Reserve Chair Janet Yellen. Bloomberg News

“A gradual approach is particularly appropriate in light of subdued inflation and a low neutral real interest rate, which imply that the [Federal Open Market Committee] will have only limited scope to cut the federal funds rate should the economy be hit with an adverse shock,” she said.

“Persistently easy monetary policy might also eventually lead to increased leverage and other developments, with adverse implications for financial stability,” she said. And given the lag with which monetary policy affects the economy, “it would be imprudent to keep monetary policy on hold until inflation is back to 2 percent.”

While the low inflation environment “likely reflects factors whose influence should fade over time,” Yellen noted, “downward pressures on inflation could prove to be unexpectedly persistent.”

Yellen said the general belief is “this year’s low inflation is probably temporary,” and inflation will rise to 2% “over the next few years.” She added, “But our understanding of the forces driving inflation is imperfect, and we recognize that something more persistent may be responsible for the current undershooting of our longer-run objective.”

Citing history, Yellen suggested, “there is a 30 percent probability that inflation could be greater than 3 percent or less than 1 percent next year.”

She said, the Fed could 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.”

While the unemployment rate suggests the labor market is at pre-crisis levels, it doesn’t prove the economy is at maximum employment because demographics and “other structural changes.” The sustainable unemployment rate may be lower than in the past, she noted.

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