Written by Steven K. Beckner

(MNI) - San Francisco Federal Reserve Bank President Janet Yellen said Monday the economy faces a long period of subpar growth, high unemployment and downward inflation pressure, and so it will continue to need "extraordinarily low interest rates."

She did not say when the Fed should start tightening monetary policy, but asserted, "I believe this is not the time to be removing monetary stimulus."

When the time does come to tighten, Yellen advised against outright sales of mortgage-backed securities and other assets from the Fed's portfolio, saying that could disrupt markets and drive up long-term interest rates just as the economy is trying to recover.

In the first instance, she said the Fed should tighten by raising the interest paid on reserves and in turn the federal funds rate and other short-term interest rates. Asset sales should come only later after the economy has demonstrated more strength and the Fed has begun tightening and should be gradual, Yellen said in remarks prepared for delivery at the University of San Diego's School of Business Administration.

Yellen, who does not have a vote on the Federal Open Market Committee this year but whose views are well respected among other FOMC members, said the economic "tide appears to have turned" and "recovery is well under way." However, she emphasized the modest and unsure nature of the recovery.

Without predicting a "double dip" recession, she suggested the recovery is vulnerable to interruption. And she almost entirely dismissed concerns that inflation could worsen in the next few years. Indeed, the opposite is more likely to occur in her view.

"Unfortunately, I'm not at all convinced that a V-shaped recovery is in the cards," said Yellen, adding "that (5.7%) fourth-quarter leap in GDP overstates the underlying momentum of the economy."

"Much of it was due to a slowdown in the pace at which businesses were drawing down inventory stocks compared with earlier in the year," she said. "Less than half of the fourth-quarter growth reflected higher sales to customers," she added. "I'd feel much more confident about the prospect for a sustained robust recovery if I saw evidence of more vigorous growth in actual sales."

"My business contacts tell me the consumer mindset is still in a fragile state," Yellen said. "The current high level of unemployment is severely restraining income and undermining confidence as people worry whether they will have a paycheck in the months ahead."

Although housing "appears to have stabilized," she said she does not "see any signs of a sharp turnaround."

In fact, she warned, in a reference to the impending end of Fed MBS purchases and the first-time homebuyer tax credit, "As support from Federal Reserve and other government programs phases out, there is a risk that the housing market could weaken again."

Meanwhile, she said, "businesses remain very nervous and exceedingly cost conscious." Tight credit is one factor hindering business spending, she said.

Echoing the concerns of many of her colleagues, Yellen said "commercial real estate remains a bleak spot and investment in nonresidential structures is likely to stay depressed for some time."

"Put it all together and you have a recipe for a moderate rate of economic growth, well below the spritely pace set in the fourth quarter," she added, projecting 3% first quarter growth, 3.5% growth for the year and 4.5% growth next year.

Among the factors restraining the pace of recovery, "wounds from the financial crisis," Yellen said, "will take a long time to fully heal."

Second, she said "losses on mortgages, commercial real estate credits, and other loans continue to mount, and the full weight of foreclosures and bank failures on the economy has yet to be felt."

What's more, although some of her FOMC colleagues have described Fed policy as "highly stimulative" or "highly accommodative," Yellen said the Fed "has faced limits in the amount of monetary stimulus we have been able to generate."

Despite its zero federal funds rate policy and massive expansion of its balances sheet, "monetary policy can't give the same kick to the economy that it delivered in past recoveries," she said.

Yellen predicted "the economy will be operating well below its potential for several years." She estimated that the "output gap" -- the difference between the actual level of GDP and the level where GDP would be if the economy were operating at full employment -- at a negative 6% and said it will take time to eliminate that gap.

"The San Francisco Fed estimates that the potential level of output is increasing roughly 2-1/2% a year due to growth in the labor force and increases in productivity," she explained. "Hence, over the next two years, potential output will increase by about 5%. My forecast is that real GDP will increase about 8% during that period, or 3 percentage points more than potential output. This implies that the output gap will shrink from its current level of negative 6% to around negative 3% by the end of 2011."

"In fact, I don't expect the output gap to completely vanish until sometime in 2013," she added.

Although "the pace of job losses has slowed dramatically," Yellen predicted "unemployment to remain painfully high for years." From January's 9.7% rate, she predicted unemployment will dip to 9.25% by the end of the year and 8% by the end of 2011 -- "a far cry from full employment."

Citing employer efforts to increase productivity by getting more out of fewer workers, Yellen said there may have been a "paradigm shift" in the labor market that would mean "the rate of job creation will be frustratingly slow."

In that climate, Yellen disagreed with those warning against accelerating inflation. She described herself as being in the camp which argues that "economic slack and downward pressure on wages and prices are pushing inflation down."

Rebuting fears that large federal budget deficits will lead to higher inflation, she said "the real danger I see from them is not inflation. Rather, they may be harmful once the economy recovers because they are apt to boost interest rates and absorb private savings that would otherwise finance productive investments."

"I believe that the more worrisome challenge for price stability over the next few years stems primarily from the sizable amount of slack in the economy," she said. "Inflation is already very low and trending downward," Yellen commented. "With slack likely to persist for years and wages barely rising, it seems quite possible that core inflation will move even lower this year and next."

Against that backdrop, Yellen said "accommodative policy is appropriate, in my view, because the economy is operating well below its potential and inflation is undesirably low. I believe this is not the time to be removing monetary stimulus."

She noted that the Fed is phasing out emergency liquidity facilities and has scheduled an end to asset purchases, but suggested actual tightening is some ways off.

"This is not the time to be tightening monetary policy," she said. "But eventually the economy will gain enough momentum and won't need today's extraordinarily low interest rates. When that time comes, we will begin to tighten policy and remove monetary stimulus."

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