By Howard Schneider
WASHINGTON (Reuters) - The U.S. economy is healthy enough for the Fed to move forward with plans to raise rates and begin winding down its massive bond portfolio, though low inflation and a low neutral rate may leave the central bank with diminished leeway, Fed Chair Janet Yellen said on Wednesday.
In what may be one of her last appearances before Congress, Yellen depicted an economy that, while growing slowly, continued to add jobs, benefited from steady household consumption and a recent jump in business investment, and was now being supported as well by stronger economic conditions abroad.
The Fed "continues to expect that the evolution of the economy will warrant gradual increases in the federal funds rate over time," Yellen said in her prepared testimony. Reductions in the Fed's portfolio of more than $4 trillion in securities are likely to begin "this year," she said.
But she also noted that given current estimates, the federal funds rate "would not have to rise all that much further" to reach a neutral level that neither encourages nor discourages economic activity. The Fed still feels the economy needs loose, or accommodative, monetary policy, so a lower neutral rate means the Fed may feel compelled to slow the pace of rate hikes down the road.
But for now, Yellen told members of the House Committee on Financial Services that the economy remains strong enough for the Fed to continue its plans to gradually tighten policy. A question and answer session with lawmakers follows her prepared remarks.
Yellen's past appearances before the House panel have sometimes involved sharp exchanges with lawmakers who think the Fed's influence over the economy has grown too strong, and who want policymakers to be guided more closely by a mathematical rule for setting interest rates.
In a report released last week the Fed compared its current policy to that prescribed by a variety of such rules. It pointed out that the choice of a rule itself involved judgments that would lead to vastly different outcomes.
Committee Chair Jeb Hensarling, an advocate of "rules-based" monetary policy, said including the rules discussion in the semiannual report was "very helpful."
Yellen, in her testimony, referred House lawmakers specifically to that section of the report.
Her appearance comes as the Trump administration mulls whether to replace her when her term ends in February.
Following her remarks, U.S. stocks rose while yields on Treasury bonds fell and the dollar declined against a basket of currencies.
According to her testimony the economy is on an even keel, near or beyond full employment and the Fed is steadily moving rates higher. The reduction in the balance sheet, which will begin slowly as the Fed reinvests only a portion of the holdings that mature each month, will mark the final exit from crisis-related policies.
One potential issue is that the Fed may be approaching a "neutral" rate even as it hopes to continue accommodating the recovery.
Estimates of the inflation-adjusted neutral rate have been falling, and by some accounts may be near zero. Yellen has said the Fed expects estimates of the neutral rate to rise over time. But unless that happens, or inflation picks up, the Fed may have only a few rate increases left before it hits a level that is no longer felt to be encouraging spending and investment.
A recent dip in inflation has been of concern among Fed officials who want to see surer progress toward the central bank's 2 percent inflation goal. Yellen, however, ascribed it to "a few unusual reductions in certain categories of prices" that would eventually drop out of the calculation.
The current situation "raises the stakes" for upcoming inflation data, said Jim Vogel, interest rate strategist for FTN Financial in Memphis, Tennessee. "People are going to be very anxious if that was just a statistical glitch...or if it is going to continue."
Otherwise, Yellen said, the economy appeared to be in a virtuous loop of hiring, spending and investment that "should increase resource utilization somewhat further, thereby fostering a stronger pace of wage and price increases."
(Reporting by Howard Schneider; Additional reporting by Karen Brettell in New York; Editing by Andrea Ricci and Chizu Nomiyama)