Sept. 4 (Bloomberg) -- Federal Reserve Bank of San Francisco President Janet Yellen said there are ``substantial'' risks of slower U.S. economic growth, and inflation is likely to slow, declining to rule out the chance of an interest-rate cut.

``I assume with pretty high probability that the next move is up and I would be quite open minded in terms of exactly when that would occur,'' Yellen told reporters today after a speech in Salt Lake City. ``Of course there is some chance'' rates could be cut, ``if things start going seriously wrong,'' she added.

Yellen is the second policy maker in two days to argue that the yearlong credit crunch has blunted the effect of the rate cuts. While most investors expect officials to keep the benchmark rate unchanged through December, there's a higher likelihood of a cut than an increase, futures prices show.

The current rate ``does not imply a highly accommodative policy stance,'' because credit conditions are ``probably more restrictive'' now than when the Fed started lowering borrowing costs a year ago, Yellen said in her speech.

The U.S. economy's acceleration to a 3.3 percent growth rate in the second quarter ``is likely to prove ephemeral,'' Yellen said today. ``My forecast is for sluggish growth in the second half of this year, with substantial downside risks -- especially emanating from the financial system.''

Yellen will vote on the rate-setting Federal Open Market Committee next year.

The U.S. is suffering a ``severe economy-wide credit crunch'' Yellen said, warning that conditions may worsen. ``My guess is that market functioning will improve in 2009, but things could get worse before they get better.''

Credit Crisis

In a speech yesterday, Boston Fed President Eric Rosengren said the U.S. credit crisis has blunted the impact of the Fed's rate cuts, signaling he opposes raising borrowing costs.

The remarks by Yellen and Rosengren contrast with some other Fed officials, who have placed greater weight on the threat of inflation.

Dallas Fed President Richard Fisher, who has dissented in FOMC votes in favor of raising rates, said today there's a 50 percent chance inflation will accelerate even amid slowing economic growth.

Directors of three of the 12 Fed district banks asked to raise the charge on loans to commercial banks ahead of the FOMC's Aug. 5 policy meeting, the central bank said this week.

Rate Outlook

The FOMC next gathers Sept. 16, when traders expect it to keep the target rate for overnight loans between banks at 2 percent for the third straight time. Futures quoted on the Chicago Board of Trade indicate an 80 percent chance the FOMC leaves the rate unchanged through year-end, with 15 percent odds on a cut, up from zero a week ago and 3 percent yesterday.

``Overall inflation over the past year has been unacceptably high,'' Yellen said today. ``But, the prognosis going forward is favorable. Inflation expectations remain relatively well contained,'' which reduces the chance that rising prices will feed into wage increases and stoke prices further, she said.

Crude oil has dropped more than 25 percent from its July 11 record of $147.27 a barrel. Should such declines fail to reverse, inflation is likely to slow, both including and excluding food and energy costs, Yellen said.

Business `Slow'

Also yesterday, the central bank's regional economic survey showed that business across most of the U.S. was ``slow'' last month, while almost all Fed districts reported pressure to raise prices because of higher commodity costs.

Yellen, who served as a Fed governor and economic adviser to President Bill Clinton in the 1990s and was a professor at the University of California at Berkeley, said she expects second- half growth to be below the long-term potential rate, ``which implies that the unemployment rate will rise,'' without giving specific figures.

The consumer price index rose 5.6 percent for the 12 months ending in July. The Fed's preferred benchmark, the personal consumption expenditures price index, minus food and energy, has been at 2 percent or higher since April 2004.

``It seems clear that inflation risks have diminished somewhat in recent months as commodity prices have come down from their highs,'' Yellen said. ``But they have by no means disappeared and are very much at the forefront of the FOMC's attention.''

About 463,000 Americans have lost jobs since January as the worst housing recession in a quarter century has curtailed spending and bank lending. The Labor Department tomorrow will report on last month's unemployment rate and the change in payrolls.

July's jobless rate of 5.7 percent is ``almost a full percentage point above the level that, in my view, is consistent with `full employment,''' Yellen said.

Economists expect annualized rates of growth of 1 percent in the third quarter and 0.4 percent in the fourth quarter, according to the median estimate in a Bloomberg Survey in early August.

To contact the reporter on this story: Scott Lanman in Washington at slanman@bloomberg.net; Steve Matthews in Salt Lake City at smatthews@bloomberg.net.

Last Updated: September 4, 2008 17:02 EDT