June 5 (Bloomberg) -- Federal Reserve Bank of San Francisco President Janet Yellen said that policy makers need to be prepared for “substantial shocks” and that rising Treasury yields may be a “disconcerting” signal of inflation fears.

“Recent experience raises the possibility that the Great Moderation is behind us, so we must be prepared for substantial shocks,” Yellen said today during a panel discussion hosted by the Fed Board of Governors in Washington. “Great Moderation” is a term used to describe the comparative economic stability seen in the U.S. and other major industrial countries, except Japan, since the mid-1980s.

Yellen’s comments on yields go beyond remarks made two days ago by Fed Chairman Ben S. Bernanke, who said in congressional testimony that the increases may reflect rising optimism about the economy and concerns about large federal deficits. Policy makers next meet June 23-24 in Washington and may consider whether to increase their planned purchases of $1.45 trillion of housing-related debt and $300 billion of long-term Treasuries.

Responding to audience questions, Yellen said that if she “had to write down a number” for the ideal long-term inflation goal, it would be 2 percent. That number is the preference of most Fed policy makers, she said, adding she would like to see more formal evaluation and research on the issue. She said she previously favored a 1.5 percent inflation rate.

“It’s a subject in which I have an open mind,” Yellen said.

Treasuries Tumbled

Treasuries tumbled today, driving two-year yields to an eight-month high, as traders began speculating the U.S. central bank will raise interest rates later this year.

The yield on the benchmark two-year note rose 34 basis points, or 0.34 percentage point, to 1.29 percent at 5:59 p.m. in New York, according to BGCantor Market Data. The jump was the biggest one-day increase since a 47 basis point surge Sept. 19, when Bernanke and then-Treasury Secretary Henry Paulson announced plans for what became the $700 billion Troubled Asset Relief Program.

Yields on the benchmark 10-year note touched 3.8972 percent, the most since Nov. 4. The yield has climbed more than 1 percentage point since the Fed announced its program to purchase long-term Treasuries in March.

Rising Treasury yields have complicated efforts by Fed policy makers to stimulate the economy. The increase is “disconcerting” if it reflects concerns about inflation and the ability of the central bank to effectively unwind its emergency programs, Yellen said.

Mixed Results

The central bank’s asset purchases and efforts to extend credit have produced mixed results, helping to lower borrowing costs while also leading to “its own set of risks and costs,” Yellen said in her presentation at a conference on research into financial markets and monetary policy.

Earlier this week, Kansas City Fed President Thomas Hoenig also expressed concern about rising yields, saying that “market participants realize that a period of high deficits and accommodative monetary policy are an invitation to increased inflation pressure.”

The conference discussion came hours after a government report today showed the U.S. lost fewer jobs than forecast in May, reinforcing signs that the deepest recession in half a century is starting to abate.

Labor Force

Payrolls fell by 345,000, the least in eight months, after a revised 504,000 loss in April, the Labor Department said today in Washington. The jobless rate increased to 9.4 percent, the highest since 1983, in part as more people joined the labor force to look for work.

Fed officials are starting to discuss how and when they will need to start tightening credit and pulling back the record injections of liquidity into the financial system. The central bank has more than doubled the assets on its balance sheet over the past year to $2.1 trillion to revive lending and end the recession.

“We do not yet have good estimates of the quantitative impact of such interventions,” she said. “We simply must understand better, and ultimately develop reliable models of, the extraordinary financial and macro linkages that produced the current crisis.”

In addition, calculating the costs and benefits of leaving the benchmark U.S. interest rate near zero needs “to incorporate greater volatility than experienced over the past quarter century,” Yellen said.

Yellen reiterated her view that she sees a stronger case for using Fed monetary policy to prick asset price bubbles that may lead to an economic crisis.

“Truly, we are sailing in uncharted waters, marking our maps with every bit of information along the way,” she said.

To contact the reporter on this story: Vivien Lou Chen in San Francisco at vchen1@bloomberg.net; Scott Lanman in Washington at slanman@bloomberg.net

Last Updated: June 5, 2009 18:03 EDT