Yellen said markets are "far from normal" at present but she sees "rays of hope" that current strains may be easing.

"Over the past month or so, for example, spreads in the markets for conventional GSE-sponsored securitized mortgages and in corporate borrowing markets have declined. Moreover, credit default swap spreads on many exposed financial institutions, a measure of their perceived chance of default, are down substantially. Treasury rates have moved up, suggesting reduced aversion to risk. And the major stock indexes have regained some ground," Yellen said at the 2008 CFA Institute's Annual Conference in Vancouver, B.C.

Under the current strain, Yellen said the level of monetary accommodation is appropriate and, together with the fiscal stimulus package, should be "sufficient to promote a gradual step up to moderate economic growth later this year."

She said the Fed's liquidity measures and accommodative rate cuts have mitigated the worst effects of the credit crunch, but they have yet to resolve it. "Indeed, my sense is that the process of resolution will unfold gradually," she added.

In the coming quarters, inflation should moderate as more slack in labour and product markets emerges and as commodity prices level off, Yellen said, noting the risk of heightened inflation expectations. "Of course, we will continue to monitor developments and act as needed to fulfill our mandate for sustainable economic growth and price stability."

Yellen admitted the Fed was "behind the curve" on some of the "risky developments that were unfolding." She noted that consumer regulations were "unfortunately insufficient to protect households from some egregious and unfair lending practices," and that the Fed "took too long to ramp up some supervisory policies in the face of mounting risks."

Holes in the regulatory framework allowed "risky activities to flourish," she said, which hurt both consumers and financial stability.

Yellen expects construction and home prices to continue falling "well into 2009," but the U.S. economy should improve somewhat in the second half of this year, she said.

In the Q&A session that followed, Yellen said that financial stability was at the core of the Fed's mission and that, by some measures, the financial market crisis was among the largest in history. She also called for supervision of firms accessing loans from the Fed, adding that there was a need to "level the playing field" among financial institutions.

Yellen explained that room for further declines in housing prices ranked among her greatest concerns.

In a Q&A to reporters, Yellen said that focusing solely on core inflation made no sense given recent movements in food and oil prices, which remain an upside risk to prices in the United States. She also said the Fed would have to be cautious in moving away from a growth-promoting monetary policy, and that she would be pleased if the U.S. economy became strong enough to support rate hikes by year-end.

Yellen also said the housing and credit crises have gone beyond the Fed's original expectations and that until the central bank instituted measures for providing liquidity, the interest rate cuts had not been having an effect.

Yellen said growth could come negative in the second quarter of 2008 and that labour markets should continue to show some deterioration. She also said that a 70s-style inflation scenario was very unlikely and would constitute a worst case scenario.

By Patrick McGee, This email address is being protected from spam bots, you need Javascript enabled to view it with contributions from Erik Kevin Franco, This email address is being protected from spam bots, you need Javascript enabled to view it