By Howard Schneider and Michael Flaherty
WASHINGTON (Reuters) - The U.S. economic recovery remains incomplete, with a still-ailing job market and stagnant wages justifying loose monetary policy for the foreseeable future, Federal Reserve Chair Janet Yellen told a Senate committee on Tuesday.
In a strong defense of the central bank's current stance, Yellen said early signs of a pickup in inflation aren't enough for the Fed to accelerate its plans for raising interest rates, a move currently expected in the middle of next year.
That could change, with interest rates rising sooner and faster, if data show labor markets improving more quickly than expected, she said.
But as it stands, "although the economy continues to improve, the recovery is not yet complete," Yellen said in semi-annual testimony before the Senate Banking Committee, repeating her focus on lagging labor force participation and weak wage growth as key to any conclusions about the economy's health.
"Too many Americans remain unemployed," Yellen said.
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U.S. stock markets dropped slightly after the release of Yellen's testimony and an accompanying monetary policy report, with shares of biotechnology and social media stocks being particularly hard hit after being singled out in the report for their "stretched" valuations.
"These are the sub-industries that have caused a lot of longtime stock watchers to scratch their heads. These companies have relative few earnings, especially in the biotech area," said Kim Forrest, senior equity research analyst with Fort Pitt Capital Group in Pittsburgh.
"I hope she (Yellen) is not surprised by what the market is doing. I'd say she'd like to deflate these bubbles with a little bit of stock talk."
In general, however, the report said current asset and security prices remain in line with "historic norms."
FED RELATIVELY UPBEAT
Yellen presented a broad overview of an economy still in transition from the 2007-2009 economic crisis. In the accompanying report, the Fed said its balance sheet would top out at $4.5 trillion when its bond-buying program ends in October, a sign of how much stimulus the central bank has had to unleash to support the economy.
With another $2.6 trillion held in reserve by banks, the report said it "will not be feasible" for the Fed to rely on the traditional Fed Funds market to manage interest rates - a judgment implicit in its recent work on new interest rate tools.
Yellen said the economy continues to generate jobs and steady growth, but she added that Fed policymakers currently expect their preferred measure of inflation to stand at between 1.5 percent and 1.75 percent for 2014, short of the central bank's 2 percent target.
The housing market remains weak, Yellen said, and business investment less than hoped.
Fed chiefs are mandated by law to report to Congress twice a year on monetary policy, and the hearing on Tuesday was Yellen's second such appearance. Her first turned into a marathon grilling about her philosophy and views of the economy.
The Fed faces a complex agenda as it weans the U.S. economy from the massive stimulus programs put in place to fight the financial crisis.
Economic data has kept Fed policymakers relatively upbeat that the economy will make steady progress towards the central bank's goals.
But there is also the potential for serious division.
Some policymakers worry the Fed is falling behind the curve on rate hikes and that Yellen is taking too much of an impromptu approach to the interest rate decision.
In her prepared testimony, she held firm to her view that low labor force participation and other labor market statistics are evidence of slack that needs to be absorbed by stronger job growth, not just a sign of unavoidable demographic change.
For now, a more dovish approach holds sway at the central bank, with several officials saying they'd tolerate inflation higher than the 2 percent target for a period of time in order to ensure growth is on track, wages are rising, and as many workers as possible have been drawn back into jobs.
Responding to questions from committee members, she said it would be a "mistake" for the Fed to adopt a strict rule for raising interest rates, something advocated by some lawmakers and Fed officials.
(Reporting by Howard Schneider; Additional reporting by Rodrigo Campos in New York; Editing by Paul Simao)