Yellen: Fed needs to keep unconventional tools at hand

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 world.

Even as rates creep up slowly and the Fed begins to trim its balance sheet, Yellen told the National Economists Club, "We must keep our unconventional policy tools ready to be deployed again...The probability that short-term interest rates may need to be reduced to their effective lower bound at some point is uncomfortably high, even in the absence of a major financial and economic crisis."

Reaching that 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 and the Fed's policy rate is rising. But Yellen and other Fed officials are 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.

Yellen's remarks served as a reminder as President Donald Trump mulls a switch at the Fed when her term expires in February. The crisis may be past, but some of the underlying dynamics in the economy may have changed in ways that will only be clear over time.

One of the possible nominees Trump has interviewed, former Fed Governor Kevin Warsh, was critical of Fed asset purchases at the time, while another, Stanford Economist John Taylor, advocates use of an interest rate rule that would have recommended higher rates through the downturn and recovery.

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)