Fed's Yellen defends past policies as Trump mulls top Fed pick

By Howard Schneider

WASHINGTON (Reuters) - Federal Reserve Chair Janet Yellen said on Friday that asset purchases and other unconventional policy tools must remain part of the Fed's arsenal as long as the economy remains stuck in a low interest-rate economy.

Yellen's remarks offered a contrast between her legacy as Fed chair with the policy views of others who President Donald Trump is considering for her position when her term expires in February. Yellen told the National Economists Club, "We must keep our unconventional policy tools ready to be deployed again."

Reaching the near-zero lower bound would force the Fed to turn to other means to stimulate the economy. Following the 2007 to 2009 financial crisis, the Fed used both a spoken commitment to lower rates and $3.5 trillion in asset purchases to pull rates lower than they would have been otherwise, boosting consumption and growth.

Those asset holdings are now on the decline, the Fed's policy rate is being increased, and the economy in general is doing well, Yellen said. But she cautioned that the world may not return to its old normal, and "future policymakers" may need to use emergency steps similar to those used in the past decade.

Persistent low inflation has caught the Fed by surprise and is "of great concern," Yellen said. She and other Fed officials are also convinced that the "neutral" rate, which neither stimulates nor discourages economic activity, is much lower than in the past, likely limiting how far the Fed can go during this rate increase cycle.

As President Donald Trump mulls a switch at the Fed, Trump is considering several possible replacements for Yellen.

One of the possible nominees Trump has interviewed, former Fed Governor Kevin Warsh, was critical of Fed asset purchases at the time, and argued that Fed has stayed too deeply involved in asset markets. Another, Stanford Economist John Taylor, advocates use of an interest rate rule that would have recommended higher rates through the downturn and recovery. Once rates reach the lower bound, moreover, Taylor's rule-based approach would likely have to give way to judgment about what steps to take.

Yellen is also being considered for reappointment, but made clear she feels the central bank needs to keep its options open for the future.

"The bottom line is that we must recognise that our unconventional tools might have to be used again," Yellen said, advising that "future policymakers" may face challenges not unlike those of the past ten years.

(Reporting by Howard Schneider; editing by Diane Craft)