Fed's Yellen sees gradual rate hikes starting this year

By Ann Saphir and Michael Flaherty

SAN FRANCISCO/WASHINGTON (Reuters) - Federal Reserve Chair Janet Yellen signalled that the U.S. central bank will likely start raising borrowing costs later this year, even before inflation and wages have returned to health, but emphasized the return to normal interest rates will be gradual.

A downturn in core inflation or wage growth could force the Fed to delay the first increase to borrowing costs since 2006, the central bank's chief said on Friday, but policymakers should not wait for inflation to near the Fed's 2-percent goal before tightening monetary policy. The Fed has held short-term borrowing costs near zero since December 2008.

After the first rate increase, Yellen said, a further, gradual tightening in monetary policy will likely be warranted. If incoming data fails to support the Fed's economic forecast, the path of policy will be adjusted, she said.

"With continued improvement in economic conditions, an increase in the target range for that rate may well be warranted later this year," Yellen said at a monetary policy conference at the Federal Reserve Bank of San Francisco.

Yellen added that while the Fed is giving "serious consideration" to beginning to reduce its accommodative monetary policy, the timing and the path of a Fed hike would depend on the incoming economic data.

"The actual path of policy will evolve as economic conditions evolve, and policy tightening could speed up, slow down, pause, or even reverse course depending on actual and expected developments in real activity and inflation," Yellen said.

U.S. Treasury yields fell and held near session lows on Friday after the mildly hawkish comments and as investors bought bonds ahead of month-end rebalancing.

Still, traders of U.S. rate futures kept their bets that the Fed will wait until October to raise rates.

"It turned out to be pretty much a replay" of last week's Fed statement, said Alfonso Esparza, senior currency Strategist at Oanda in Toronto. "They're waiting for the data," he said in reference to Fed policymakers.

With labour markets looking set to improve further, and one-time downward pressure on inflation likely to dissipate, a "modest" rate rise would be unlikely to put a halt to jobs growth, Yellen said. At the same time, she said, raising rates too fast could undercut an economy that has for years been labouring against lingering headwinds from the severe recession.

CAUTIOUS APPROACH

Yellen, returning to the regional Fed bank she used to run, is under pressure to begin tightening monetary policy without disrupting the U.S. economic recovery underway.

The Fed signalled in its March statement that it was moving a step closer toward raising rates, though the central bank cut its economic outlook and slashed its median estimate for the federal funds rate, in a sign that it was prepared to move more slowly than the market expected ahead of the meeting.

While June remains on the table for the timing of the Fed's first rate hike, Yellen's comments since then suggest the central bank is more likely to move later in the year.

With the unemployment rate dropping to 5.5 percent last month, and after more than six years of loose monetary policy, the Fed is eager to begin raising rates and returning to more normal policy.

Several Fed officials have said the central bank has waited too long to bump rates higher, and the delay risks stoking inflation and asset bubbles.

But inflation has remained stubbornly low, complicating the Fed's plan to part ways with its accommodative monetary policy.

Yellen said that if economic conditions evolve how the Fed's policy setting committee anticipates, "I would expect the level of the federal funds rate to be normalized only gradually, reflecting the gradual diminution of headwinds from the financial crisis and the balance of risks I have enumerated of moving either too slowly or too quickly."

(Reporting by Ann Saphir and Michael Flaherty; Editing by Diane Craft)