Yellen's Q&A testimony to Senate Banking Committee

WASHINGTON (Reuters) - Following are highlights from the question and answer session of Federal Reserve Chair Janet Yellen's testimony before the Senate Banking Committee on Tuesday. YELLEN ON BUBBLES, DAMAGE TO ECONOMY OF RAISING RATES The slate of regulations put in place "diminishes the odds that risks will develop. (But) if there is an asset bubble and it bursts we are not going to be able to catch every asset bubble that develops." "Were we to significantly raise interest rates to deal with (asset bubbles) we should expect even worse performance on those important goals that Congress has established for the Federal Reserve. If we were to weaken the economy, it's not even clear that we would be mitigating financial stability risks overall... (and) we should be no means think that it would be costless." YELLEN ON LENDING STANDARDS, INTEREST RATE RISK "We are seeing a deterioration in lending standards. And we are attentive to risks that can develop in this environment, for example that banks or others may be taking on interest rate risk and, when interest rates ultimately begin to rise, that if firms or individuals have taken risks and aren't prepared to deal with them that can cause distress." YELLEN ON STUDENT BORROWING "The growth in student debt has been really dramatic... When you look at the numbers on student debt, it has to be a significant concern." YELLEN ON REQUIRING FED TO SPECIFY A POLICY RULE "No central bank in the world follows a mechanical, mathematical rule, and I think it would be a terrible mistake to ask the Federal Reserve to specify a mathematical rule... "If we were following a specific mathematical rule I really think performance in this recovery would have been dreadful. "There are special factors and structural changes that need to be taken into account that would make me very disinclined to follow a mathematical rule. But I think it is important that a central bank behave in a systematic and predictable way, and to explain what it is doing and how it sees itself as likely to respond to future economic developments as they unfold, and that is precisely what we are trying to do with our forward guidance." YELLEN ON MAKING SURE NO FINANCIAL INSTITUTIONS ARE TOO BIG TO FAIL "We are completely committed with trying to deal with too-big-to-fail. We have put in place numerous steps and have more in the works that will strengthen these institutions, force them to hold a great deal of additional capital and reduce odds of failure." YELLEN ON OTHER POTENTIAL SOURCES OF SYSTEMIC RISK "Systemic risk in the financial system is not purely a question of too-big-to-fail institutions... We could have systemic risk if a large number of smaller institutions are hit for some reason." YELLEN ON HEADWINDS AND FISCAL POLICY "I do agree with the view that there are substantial headwinds facing the economy. One example would be that we see in surveys of households that their expectations about their future finances and growth in their real incomes is exceptionally depressed and I think that's a factor that is depressing spending. We see in the housing market were we had some progress but it now looks like it's stalled... And fiscal policy has been a factor in my view holding back recovery and that's what monetary policy has had to counteract and that's in part why we've needed such an accommodative monetary policy… The economy is making progress… But to the extent that even when the economy gets back on track it doesn't mean that these headwinds will have completely disappeared…" YELLEN ON REACH-FOR-YIELD, FINANCIAL INSTABILITY "An environment of low interest rates in general ... (does) have an incentive to push individuals to look for yield. That is both a good thing and a bad thing. "On the one hand we need healthy risk-taking in order to spur recovery, and low interest rates I think have had a positive effect on helping the recovery. But of course we have to be careful about looking for situations where low rates may be incenting behavior that can be dangerous to financial stability, particularly ... an area like leveraged lending where we are seeing marked deterioration in underwriting standards. It looks like it could be part of a reach-for-yield and we're trying to deal with that through supervisory means. "But the kind of broad-based increase in leverage in the economy and maturity transformation and credit growth that one tends to see in the situation where there are intense financial stability risks, I don't think we see those things. At this point they are more isolated and not more broad-based in general." YELLEN ON THE OUTLOOK FOR ASSET PURCHASES "Purchases would cease after October, but if there were to be some very significant change in the outlook that we see between now and October so that we lost confidence that the labor market will improve for some reason, or that inflation would move back up to 2 percent, then we would have to rethink that plan." YELLEN ON LONGER-TERM PLAN FOR RATE RISES "Even after we think the time has come to raise rates, we think it will be some considerable time before we move them back to historically normal levels... Of course we need to be cautious to make sure the economy continues to recover." "This is not a pre-set course. If we were to judge the conditions changed significantly, it's not locked in stone." YELLEN ON WAGE INFLATION "While rising compensation or wage growth is one sign that the labor market is healing, we are not even at the point where wages are rising at a pace that they could give rise to inflation. In fact real wages have been rising less rapidly than productivity growth; what we’ve seen is a shift in the distribution of national income away from labor and toward capital. "There is some room there for faster growth in wages and for real wage gains before we need to worry that's creating an overall inflationary pressure for the economy. That's something we are watching closely." YELLEN ON USING REPURCHASE OPERATIONS TO HELP CONTROL FUNDS RATE "We've indicated that the main tool we will use is the interest rate we pay on overnight reserves. The overnight RP facility that you refer to I think of as a back-up tool that we will use to help us to control the federal funds rate, to improve our control over the federal funds rate. I think it's a very effective and useful tool. We have gleaned that from the initial testing that we've done. But as you mentioned, we do have concerns about allowing that facility to become too large or to play too prominent a role…" YELLEN ON WHETHER CONGRESS SHOULD REQUIRE A FED BOARD SEAT BE FILLED BY A COMMUNITY BANKER "I am very positive on the idea of having a community banker appointed to the board. That said, I don't support requiring it by legislation... That's a road that could go further in a direction that would worry me. If we're earmarking, we could end up earmarking each seat for particular kinds of expertise." YELLEN ON LONG-TERM UNEMPLOYMENT "While long-term unemployment remains at exceptionally high levels and is a grave concern, I do think we are seeing improvements as the job market is strengthening." YELLEN ON TIMING OF RATE RISE The Federal Open Market Committee will be looking at "maximum employment and price stability... There's no formula and no mechanical answer that I can give you about when the first rate hike will occur. It will depend on the progress of the economy and how we assess it based on a variety of indicators." YELLEN ON ECONOMY, RATE HIKE OUTLOOK "My reading at the present time is that the (Q1) GDP decline is largely due to factors I would judge to be transitory, and I do think that negative number substantially understates the momentum in the economy. Of course this is something we need to watch carefully and are doing so.... "The Federal Reserve does need to be quite cautious with respect to monetary policy. We have in the past seen sort of false dawns, periods in which we thought growth would speed, pick up and the labor market would improve more quickly, and later events would prove those hopes to be unfortunately over-optimistic. "We are watching very carefully. Especially when short-term overnight rates are at zero so we have no ability to lower them further, we need to be careful to make sure the economy is on a solid trajectory before we consider raising interest rates." (Washington ecoomics team)