The U. S. economy may be nearing an inflection point and there is some basis for optimism despite a lot of downside risk, Janet Yellen, President of the Federal Reserve Bank of San Francisco said in a speech late Tuesday. Calling the current recession deep and worrisome, she said the recovery, when it begins, is likely to be quite gradual compared with those following previous deep recessions.

Speaking at the Haas Business School of the University of California, Berkeley, Yellen struck a positive note saying, For the first time in a while, there is some good news to savor. Painting due caution, she said, But, when it comes to assessing the future of the economy, the dominant theme is uncertainty.

The ongoing recession, running its sixth quarter, is shaping up as the most severe downturn since the Great Depression, the policymaker said. Official data released last week revealed that gross domestic product decreased at an annual rate of 6.1% in the first quarter compared with a 6.3% drop in the fourth quarter largely due to a steep decline in private inventories.

The fact that I can now talk about crosscurrents may mean that the economy is reaching an inflection point. Citing the first-quarter data, Yellen said the necessary inventory correction may be quite far along and thee are some hints of stabilization in the housing sector.

According to Yellen, the most likely scenario is that real GDP will advance at a low, but positive rate in the second half of this year followed by trend-like growth in 2010. I expect the U.S. recovery to be frustratingly tepid once it does get started. It likely will take several more years to bring unemployment back to its long-run equilibrium value, she said.

Yellen, who is a voting member of the Federal Open Market Committee this year, feels the economy is vulnerable to a number of downside risks, including the possibility of another disruptive financial event.

On the labor market front, however, recent news is still very weak, Yellen noted. The 1.7 percentage points rise in the jobless rate over the past four months actually understates the true magnitude of the labor market downturn, she added. Further she said the incidence of permanent, as opposed to temporary, layoffs is unusually high compared with past downturns.

Regarding monetary policy, Yellen said it is difficult to tell if unconventional monetary policies will be as effective in promoting recovery as easing the funds rate has been in the past. According to her, these initiatives appear to be lowering longer-term interest rates and easing financial conditions more generally.

On April 29, the policymaking arm of the Federal Reserve voted unanimously to keep the target range between 0 and 0.25 percent and left the amounts associated with quantitative easing steady. The Fed announced that they would have purchased $300 billion in longer-term treasury securities by autumn.

Yellen do not see a surge in inflation as very likely. I see little basis to worry that we will develop an inflation problem, she said, while adding that there is a remote chance of deflation.

However, she noted that the Fed will need to withdraw monetary support once the credit crunch eases and the economy rebounds. If the Fed were to fail to tighten the stance of monetary policy quickly enough, we would see higher inflation. The simplest approach, according to Yellen, to tackle the prospect of higher inflation in such a context would be to shrink the Fed balance sheet by selling the Treasuries, agency debt, and agency MBS accumulated during the crisis.

Further, Yellen said the Fed could extend additional support to financial markets when economy rebounds by adopting a totally new approach of issuing interest-bearing debt to private investors. However, this approach, an alternative to raising the interest rate on bank reserves, requires Congress approval. These two measures would help in accomplishing a tightening of policy while maintaining our support of credit markets, she said.

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