Fed still set to tighten, Yellen says

The Federal Reserve will continue to tighten its monetary policy as falling unemployment on expectations for further moderate growth in the economy, the head of the central bank said.

But her remarks also appeared to be laced with several caveats.

Policymakers still thought it likely that they would start to unwind the Fed's balance sheet in 2017, as long as their projections for growth panned out, she explained in her semi-annual report to Congress.

In remarks prepared for her speech, US central bank chair Janet Yellen pointed out that the unemployment rate had fallen "modestly" below the Fed's estimate of its sustainable long-term level.

Similarly, a broader measure of unemployment, which also takes into account those marginally attached to the labour force and those who would like to work more, was again near its lowest levels from before the last recession, she said.

"With further gradual adjustments in the stance of monetary policy, the economy will continue to expand at a moderate pace over the next couple of years, with the job market strengthening somewhat further and inflation rising to 2%."

And now for the caveats ...

However, Yellen said there was uncertainty about how inflation would respond to shrinking slack in the economy.

The possibility of changes to fiscal and other government policies in the US and elsewhere were another element of undertainty, according to the Fed chief.

Furthermore, the neutral interest rate for the US economy was currently quite low.

That meant that the "federal funds rate would not have to rise all that much further to get to a neutral policy stance."

At the end of her written testimony to the US House of Representative's Financial Services Committee, Yellen also indicated that rate-setters would row back on any unwinding of the Fed's balance sheet if economic conditions deteriorated significantly.

"However, the Committee would be prepared to resume reinvestments if a material deterioration in the economic outlook were to warrant a sizable reduction in the federal funds rate.

"More generally, the Committee would be prepared to use its full range of tools, including altering the size and composition of its balance sheet, if future economic conditions were to warrant a more accommodative monetary policy than can be achieved solely by reducing the federal funds rate."

Commenting on her testimony, Mickey Levy and Roiana Reid at Berenberg Capital Markets said: "Note that the real Fed funds rate remains negative but less so as a consequence of the downward drift in inflation as well as the Fed rate hikes.

"A December rate increase would put the real Funds rate close to zero, if only part of the recent decline in inflation is retraced. Combined with the Fed’s balance sheet, that would leave monetary policy accommodative. But if inflation does not rebound, the Yellen-led Fed may slow its pace of normalization."