By Ros Krasny
LA JOLLA, California (Reuters) - The risk of inflation is beginning to outweigh the risk of a deteriorating U.S. economy, a top Federal Reserve policy-maker said on Monday, indicating that the Fed could be leaning toward raising interest rates.
Janet Yellen, president of the San Francisco Fed, said that with worst-case scenarios having been skirted and inflation risks on the rise, interest rate policy is tilting in a "slightly tighter" direction.
"On a continuum I would say things are shifting to somewhat more inflation risk," Yellen told reporters after a speech at the University of California San Diego.
Still, Yellen said she was "agnostic" on the timing of a potential rate hike by the Federal Open Market Committee, saying only that "readiness is all" and that the central bank was "prepared to act as needed."
Financial markets imply the FOMC will start raising rates by October, having cut the benchmark federal funds rate to 2 percent by late April from 5.25 percent in September 2007.
"I am somewhat reassured by the recent data, which suggest that my biggest fears on the downside have, so far, been avoided," Yellen said. Growth is likely to be "reasonably weak" for the rest of 2008 before picking up.
By contrast, "inflation has become an increasing concern," she said, adding that headline inflation is likely to run "much higher" than desired for the next few quarters. Core prices, which exclude volatile food and energy prices, are also set to rise as businesses pass on their higher costs.
Both price measures should moderate in 2009 on the heels of greater slack developing in the labor market and a probable leveling off in oil and food prices, she said, adding that she did not envision commodity prices continuing to spiral upward.
Yellen said there is no sign so far of generalized wage pressure in the United States, and inflation expectations are "reasonably well anchored" as well, but that the Fed was on alert.
"The risks to inflation are likely not symmetric and they have definitely increased. We cannot and will not allow a wage-price spiral to develop," she said.
Second-round inflation, in which higher costs are used as leverage to drive up wages, is more apparent in Europe right now than in the United States, Yellen said.
Yellen is not a voting member this year of the U.S. central bank's Federal Open Market Committee, which sets monetary policy. She will vote on the FOMC in 2009.
DOUBLE, DOUBLE, TOIL AND TROUBLE
The economy was likely to grow "only modestly" for the balance of 2008 before picking up in the new year, helped by the lagged effect of the Fed's spate of interest rate cuts, Yellen said.
She said the federal fiscal stimulus package had been helpful in shoring up consumer spending recently and said she did not see a need for a second package.
Some economists have warned of a potential "double-dip" slowdown if U.S. growth stagnates again in late 2008 and into 2009 as the fiscal help fades away.
But Yellen said the "three ghastly witches brewing up trouble" in the United States economy -- the housing market, financial markets, and commodity prices -- were likely to be less of a factor by late this year.
Yellen told reporters she was surprised the U.S. jobless rate did not dip in June, when it held steady at 5.5 percent, but that the peak unemployment level in the current cycle would likely be below 6 percent.
CREDIT STILL TIGHT
Despite the Fed's series of rate cuts, credit conditions are still tighter than they were before the worst of the global credit crunch descended in August 2007, Yellen said.
The level of the fed funds rate is not a good indicator of the overall availability of lending, she said, but without the Fed's sharp rate cuts lending would be "incredibly tight."
A months-long shakeout in financial institutions -- characterized by less reliance on debt and more on equity financing -- is likely to continue, she said.
"Progress toward sturdier and more efficient financial markets is going to take some time, and that means the flow of credit is likely to remain impeded," Yellen said.
She said that the supply shocks hitting the U.S. economy in the form of higher gasoline and food prices, and the subsequent stagnation or decline in real wages, are outside of what the Fed can control through monetary policy.
"It's sobering. It's depressing," she told reporters. "You bet."
(Editing by Leslie Adler)