Fed taking 'forceful action' on economy: Yellen

In an address to the politically influential AFL-CIO, the largest U.S. labor group, Yellen, a potential successor to Fed Chairman Ben Bernanke next year, bemoaned the unusually weak nature of the economic expansion.

“The gulf between maximum employment and the very difficult conditions workers face today helps explain the urgency behind the Federal Reserve's ongoing efforts to strengthen the recovery,” Yellen said.

“We have taken, and are continuing to take, forceful action to increase the pace of economic growth and job creation.”

The U.S. economy contracted slightly in the fourth quarter of 2012 and, while that decline is seen as temporary, continues to grow at or below 2 percent, far below the rate economists say is needed to bring down the 7.9-percent unemployment rate.

Yellen pointed to erratic U.S. budget policy as one source of weakness in the recovery.

“I expect that discretionary fiscal policy will continue to be a headwind for the recovery for some time, instead of the tailwind it has been in the past,” she said.

In response to the deep financial crisis and recession of 2007-09, the Fed lowered interest rates effectively to zero and bought over US$2 trillion in mortgage and Treasury securities in an effort to keep down long-term interest rates.

It began a new, open-ended round of US$85 billion monthly bond purchases in September.

Austerity: More Harm Than Good?

Austerity policies in the United States and Europe that sharply cut spending to reduce budget deficits could be self-defeating if they derail economic growth, Yellen said.

“Both for the United States and for Europe ... fiscal austerity does raise unemployment, weaken the economy and ... in addition undermines the goals for which it is designed to achieve,” Yellen said.

Yellen argued that the primary cause of high unemployment is a shortage of demand due to the ebb and flow of the business cycle, not structural factors. That suggests monetary policy can be helpful to offset the labor market's troubles.

Long-term unemployment is a serious problem not only for those affected, but also for the economy as a whole since it could hurt the nation's growth potential, Yellen said.

Some analysts worry the Fed's stimulus policies will spark future inflation, but the central bank maintains it has all the tools it needs to remove liquidity from the financial system when the time comes.

Policymakers do not think that is any time soon. They have vowed to keep purchasing assets as long as the U.S. employment outlook fails to make substantial improvement and to keep rates near zero until the jobless rate falls to 6.5 percent, as long as inflation remains under control.

Yellen said that, when the time comes to tighten monetary conditions, the Fed has the necessary tools, particularly the ability to pay interest on bank reserves to remove liquidity from the financial system.

Asked about the role of a large U.S. trade deficit at a time when some analysts have voiced fears of competitive exchange rate devaluation or “currency wars,” Yellen sounded an optimistic note.

“For quite some period of time now, the U.S. dollar has been depreciating very gradually in real terms and I think it has made a very substantial difference to the U.S. current account deficit that has come down a long way and is no longer on what I would to refer to as an unsustainable course,” Yellen said. “So I think that we have made progress in that regard.”

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