Yellen: Keeping rates low may heal economy

The Federal Reserve may want to keep interest rates lower for longer to reverse the prolonged negative effects of the Great Recession, Fed Chair Janet Yellen said in prepared remarks she planned to deliver at 1:30 p.m.

Yellen did not specifically address the prospect that the Fed will raise its key interest rate in coming months for the first time in 2016. Most Fed policymakers predict they will lift the rate by year-end, and Yellen has not discouraged that view.

But her comments are generally consistent with the Fed’s decision to delay a rate increase at its September meeting and with the more gradual path of hikes that Fed officials forecast last month.

“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,” she said in the text of the speech she was slated to give in Boston, sponsored by the Federal Reserve Bank of Boston.

The Fed chief also cautioned, however, that if low rates remain in place too long, it “could have costs that exceed the benefits by increasing the risk of financial instability or undermining price stability,” she said.

She added that the benefits and costs “remain hard to quantify, and other policies might be better suited to address the supply side of the economy.”

Yellen said the traditional economic view has been that changes in the aggregate demand of an economy don’t affect its aggregate supply, which depends on the amount of output an economy is capable of producing.

But that hasn’t been the case since the recession ended in 2009, Yellen noted, adding that the level of potential output is 7% below “what would have been expected based on its pre-crisis trajectory.”

For example, she said, the recession was so severe that it prompted many discouraged Americans to drop out of the labor force and reduced immigration, shrinking the U.S. labor supply. It also hurt productivity growth, she said, as businesses cut back on capital investment and research and development.

But she suggested it may be possible to reverse those effects “by temporarily running a ‘high-pressure economy,’” in which demand is high and the labor market remains tight.

“Increased business sales would almost certainly raise the productive capacity of the economy by encouraging additional capital spending,” she 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.”

That largely mirrors what Yellen argued last month when she explained why Fed policymakers decided to leave interest rates unchanged for the time being.

“The economy has a little more room to run than might have been previously thought,” she told reporters. She said discouraged workers have been drawn back into a tight labor market in which demand for employees has risen.

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