Fed's Yellen says rate hike may be warranted later this year

By Ann Saphir and Michael Flaherty

SAN FRANCISCO/WASHINGTON (Reuters) - An interest rate hike by the Federal Reserve may be warranted later this year, with a gradual path expected to follow, although a downturn in core inflation or wage growth could force it to hold off, the central bank's chief said on Friday.

Fed Chair Janet Yellen said that after the first rate increase a further, gradual tightening in monetary policy will likely be warranted. If incoming data fails to support the Fed's economic forecast, the path of policy will be adjusted, she said.

"With continued improvement in economic conditions, an increase in the target range for that rate may well be warranted later this year," Yellen said in prepared remarks at a monetary policy conference at the Federal Reserve Bank of San Francisco.

Yellen added that while the Fed is giving "serious consideration" to beginning to reduce its accommodative monetary policy, the timing and the path of a Fed hike would depend on the incoming economic data.

"The actual path of policy will evolve as economic conditions evolve, and policy tightening could speed up, slow down, pause, or even reverse course depending on actual and expected developments in real activity and inflation," Yellen said.

With labour markets looking set to improve further, and one-time downward pressure on inflation likely to dissipate, a "modest" rate rise would be unlikely to undercut the recovery, Yellen said.

Yellen made clear a rate rise would not be contingent on an increase in either core inflation or wages, although a deterioration in either could prompt her to delay tightening.

Yellen, returning to the regional Fed bank she used to run, is under pressure to begin tightening monetary policy, while at the same time being careful not to disrupt the U.S. economic recovery underway.

The Fed signalled in its March statement that it was moving a step closer toward raising rates, though the central bank cut its economic outlook and slashed its median estimate for the federal funds rate, in a sign that it was prepared to move more slowly than the market expected ahead of the meeting.

While June remains on the table for the timing of the Fed's first rate hike in a decade, the dovish tone from the March statement and from Yellen's press conference indicated the central bank was more likely to move in September or later.

With the unemployment rate dropping to 5.5 percent last month, and after more than six years of loose monetary policy, the Fed is eager to begin raising rates and returning to more normal policy.

Yellen noted in her remarks that U.S. payroll gains have averaged 275,000 per month over the past year.

Several Fed officials have said the central bank has waited too long to bump rates higher, and the delay risks stoking inflation and asset bubbles.

But inflation has remained stubbornly low, complicating the Fed's plan to part ways with its accommodative monetary policy.

Yellen said that if economic conditions evolve how the Fed's policy setting committee anticipates, "I would expect the level of the federal funds rate to be normalized only gradually, reflecting the gradual diminution of headwinds from the financial crisis and the balance of risks I have enumerated of moving either too slowly or too quickly."

(Reporting by Ann Saphir and Michael Flaherty; Editing by Diane Craft)