Yellen Says Fed Should Avert a Rise in Wages, Prices (Update1)

July 7 (Bloomberg) -- Federal Reserve Bank of San Francisco President Janet Yellen said the central bank shouldn't allow any increase in wages and prices to fuel inflationary pressures as sluggish U.S. economic growth quickens next year.

The Fed ``cannot and will not allow a wage-price spiral to develop,'' Yellen said today at a conference at the University of California-San Diego. The economy will ``grow only modestly for the remainder of the year,'' while picking up in 2009.

The worst housing slump in 25 years, a decline in credit availability and record gasoline prices have impeded economic growth. Employers cut jobs for a sixth straight month in June, bringing losses to a net 438,000 jobs so far this year.

``Over time, the drag from housing will wane and credit conditions should improve,'' Yellen said. Recent data on the economy ``suggest that my biggest fears on the downside have so far been avoided.''

The Fed last month kept its benchmark rate at 2 percent, pausing after seven consecutive reductions since September. The Federal Open Market Committee said downside risks to growth had ``diminished somewhat'' and ``upside risks to inflation and inflation expectations have increased.''

The FOMC is committed to shielding the economy from a 1970s-style combination of rising inflation and recession, Yellen said.

Slow Growth

While increasing prices and slow growth put the Fed ``between a rock and a hard place,'' she said the Fed would probably still move to limit inflation. ``If we saw a wage-price spiral developing, then we need to act,'' she said in the question period. ``Nobody wants a repeat of'' the 1970s.

Policy makers need to watch for sudden changes in the economy and financial markets, Yellen said. ``We will monitor developments carefully and be prepared to act as needed to fulfill our mandate for sustainable economic growth and price stability,'' she said.

Traders see a 58 percent chance the Fed will increase its target rate in September, amid rising inflationary pressures from food and gasoline prices. They predict no change at the August meeting.

``Headline inflation is likely to remain much higher than I would like over the next few quarters,'' she said. ``My best guess, which could easily be wrong, is that, consistent with futures prices, commodity prices will level off and cease to put direct upward pressure on headline inflation.''

Consumer Prices

Energy and food prices pushed the consumer price index up 4.2 percent during the 12 months ending in May. Excluding food and energy, prices rose 2.3 percent during the same period.

``Markets remain very fragile,'' Yellen said. ``For example, credit-default-swap spreads for many financial institutions are again on the rise, the debt ratings for several important bond insurers have been cut and stock prices for financial institutions have plummeted.''

Even with cuts in the Fed's target rate, credit availability and costs remain ``tight,'' she said in the question period.

``Companies and households do not borrow at the federal funds rate,'' and borrowing rates for consumers remain comparatively high, she said. The Fed has ``stopped credit conditions from tightening even more.''

The world's biggest banks and securities firms have reported $401 billion in asset writedowns and credit losses stemming from the collapse of the U.S. subprime-mortgage market.

Yellen served as a Fed governor in Washington from 1994 to 1997, under Chairman Alan Greenspan, and has been leader of the San Francisco Fed since 2004.

To contact the reporters on this story: Steve Matthews in Atlanta at smatthews@bloomberg.net; Vivien Lou Chen in San Francisco at vchen1@bloomberg.net