(Adds more from speech, market reaction)
By Howard Schneider and Svea Herbst-Bayliss
BOSTON Oct 14 The Federal Reserve may need to
run a "high-pressure" economy in order to reverse damage from
the crisis that depressed output, sidelined workers and risks
becoming a permanent scar, Fed Chair Janet Yellen said in a
broad review of where the recovery may still fall short.
Though not addressing interest rates or immediate policy
concerns directly, Yellen's lunch address on Friday to a
conference of policymakers and top academics laid out the
deepening concern at the Fed that U.S. economic potential is
slipping - and may need aggressive steps to rebuild it.
The question, Yellen said, is whether that damage can be
undone "by temporarily running a 'high-pressure economy,' with
robust aggregate demand and a tight labor market. One can
certainly identify plausible ways in which this might occur."
"Increased business sales would almost certainly raise the
productive capacity of the economy by encouraging additional
capital spending, especially if accompanied by reduced
uncertainty about future prospects," Yellen said. "In addition,
a tight labor market might draw in potential workers who would
otherwise sit on the sidelines and encourage job-to-job
transitions that could also lead to more efficient - and, hence,
more productive - job matches. Finally, albeit more
speculatively, strong demand could potentially yield significant
U.S. stocks posted further gains after Yellen's remarks,
while the dollar dropped and Treasuries rose, pushing yields on
the 2-year note to session lows.
Her remarks, while pointing largely to research she feels
needs to be done, nevertheless add an important voice to a
debate that is intensifying within the Fed over whether the
economy is close enough to normal to need steady rate increases,
or whether it remains subpar and scarred.
That could figure importantly in coming debates over rate
policy, and over whether support is building at the Fed to risk
letting inflation move above its 2 percent target in order to
employ more workers and perhaps encourage more investment.
From weak inflation to the effect of low interest rates on
spending, little in the economy has been acting as the Fed
Yellen said it may be the case that the crisis has done such
permanent damage that fiscal and monetary officials will have to
retool how they approach their jobs. For central bankers, that
would mean keeping a broader set of less conventional tools at
the ready, and using them more quickly in a new downturn. The
aim, she said, would be to avoid further scarring.
"This post-crisis experience suggests that changes in
aggregate demand may have an appreciable, persistent effect on
aggregate supply - that is, on potential output," Yellen said.
"If strong economic conditions can partially reverse
supply-side damage after it has occurred, then policymakers may
want to aim at being more accommodative during recoveries than
would be called for under the traditional view that supply is
largely independent of demand," Yellen said. It would "make it
even more important for policymakers to act quickly and
aggressively in response to a recession, because doing so would
help to reduce the depth and persistence of the downturn."
With public expectations about inflation so hard to budge,
Yellen said that tools like forward guidance, "may be needed
again in the future, given the likelihood that the global
economy may continue to experience historically low interest
rates, thereby making it unlikely that reductions in short-term
interest rates alone would be an adequate response to a future
(Reporting by Howard Schneider and Svea Herbst-Bayliss; Editing
by Andrea Ricci)