Yellen: Gradual rate hikes appropriate given uncertainty in U.S. economy

Federal Reserve chair Janet Yellen, citing "considerable uncertainty" in the U.S. economic outlook and "vulnerabilities" from abroad, says the U.S. central bank will proceed "cautiously" when raising interest rates and sees a "gradual" pace of rate increases.

Yellen's comments on the U.S. economy and monetary policy, as well as global headwinds from China and a potential shock if Britain votes to leave the European Union, came in the first day of two days of testimony before Congress.

Her testimony comes less than a week after the Fed broke from its two-day June meeting and Yellen told investors that the Fed not only wasn't hiking rates in June but was also dialing back the number of interest rate hikes it sees in 2017 and 2018 amid an acknowledgment that U.S. economic growth will stay in the sub-par 2% range until at least through 2018.

The Fed's recent comments that an even more gradual pace of rate hikes make sense now run counter to Fed communication in the weeks heading up to the June meeting when various Fed officials, including Yellen, were optimistic about the ability of the economy to withstand a series of gradual rate hikes beginning as early as this summer. The Fed has yet to hike interest rates in 2016, after boosting rates back in December for the first time in nearly a decade.

In her prepared remarks Wednesday, Yellen said "considerable uncertainty about the economic outlook remains."

The Fed chair also ticked off a number of other risks that are giving the Fed pause and which make a less-aggressive approach to interest rate hikes appropriate.

One downside risk pertains to flagging U.S. growth. The Fed fears that domestic demand at home "might falter." Another domestic headwind that the Fed chair would not rule out was the prospect of "slow productivity growth" continuing into the future.

Yellen outlined a pair of international headwinds that the Fed is also closely monitoring. She noted that Thursday's coming vote in Britain on whether to exit or stay in the European Union is high on the list of potential risks.

"One development that could shift investor sentiment is the upcoming referendum in the United Kingdom," Yellen wrote. "A U.K. vote to exit the European Union could have significant economic repercussions."

In the question-and-answer session that followed her introductory remarks, Yellen expounded on the Fed's concerns: "I think it (a Brexit) would usher in a period of uncertainty. It is very hard to predict. It could be period of financial market volatility that could impact financial market conditions and impact our economic outlook. It is quite uncertain, but we are closely monitoring it."

And even though Yellen said some of the headwinds that China, the world's second-biggest economy, has been facing appear to have eased somewhat, Yellen still warned that China remains a worry.

"China continues to face considerable challenges as it rebalances its economy toward domestic demand and consumption and away from export-led growth," she said in her prepared statement.

In her update on the U.S. economy, Yellen was optimistic looking over the long term, saying she is "optimistic that we will see further improvements in the labor market and the economy more broadly over the next few years."

But, the short-term outlook is less certain, she added.

After a weak first quarter, "available indicators point to a noticeable step-up in GDP growth in the second quarter," she said. Yellen, however, countered that upbeat assessment by noting that "the pace of improvement in the labor market appears to have slowed more recently."

Yellen also stressed that labor market conditions "still look favorable," and that it is important "not to overreact to one or two (weak)  reports." U.S. job growth in both May and April came in well-below expectations, and that slowing trend in the labor market was one of the reasons the Fed opted to hold off on rate hikes at its June meeting.

Follow Adam Shell on Twitter: @adamshell.