The Yellen view: one of the Federal Reserve system's most experienced policy strategists offers her insights. A TIE exclusive interview.

• Position: Interview

TIE: What is your assessment of the U.S. economy? We recently saw some spending data on the weak side, although the general consensus is that the economy is doing well. What is your view, particularly given any impact from the rise in oil prices?

Yellen: I am in general agreement with the consensus, although higher oil prices have taken a toll both on households and on businesses. That could explain why a "soft spot" emerged both in consumer and capital spending toward the end of the first quarter. It is worth remembering that we saw a similar "soft spot" in consumer spending in the spring and early summer of 2004, also following a spike in oil prices. Fortunately, it proved to be transitory: the growth rate of consumer spending rebounded pretty quickly. I am hopeful that the recent soft spot will similarly prove to be short-lived, although it suggests some downside risks for economic growth.

The fundamentals underlying business investment seem very strong at the moment and household spending has been supported by rising disposable income, rising net worth, due in part to house prices, and low interest rates. And oil prices have backed off their recent highs. So, on balance, my outlook is for sustainable growth going forward--enough above trend to gradually erode the remaining slack in labor markets but not so robust that I would worry about the economy substantially overshooting full employment. Over the past twelve months, we've had strong months alternating with weaker months, but nonfarm payroll jobs grew by 165,000 per month on average, which was enough to move the unemployment rate down from around 5.6 percent to 5.1 percent. There is a lot of uncertainty about the amount of slack that remains in the labor market, but 5.1 percent comes reasonably close to common estimates of "full employment." Even with the recent "soft spot" in spending, job gains averaged 180,000 per month during the first five months of 2005.

On the inflation front, we have seen some intensification of inflation and pricing pressures over the last few months. We now hear more anecdotes about businesses being able to pass along price increases resulting from higher energy, raw materials, and transportation costs. The main inflationary drivers at this point come from higher oil prices, increases in commodity prices due to robust growth in the global economy, especially China, and the decline in the dollar, which has boosted import prices somewhat. The impact of these "supply shocks" is showing up not only in headline inflation but also, to some extent, in core consumer prices. We see it in both the consumer price index and the core PCE [personal consumption expenditures] price index.

However, to the extent that these costs are being passed through into prices, they should result in only one-time boosts to the price level, not faster inflation on an ongoing basis. On balance, I feel pretty comfortable about the outlook for inflation because the fundamentals governing the evolution of unit labor costs are favorable. The pace of structural productivity growth remains quite strong--it keeps surprising me on the upside. And wage and overall compensation pressures are modest, in spite of ongoing increases in health insurance costs. In addition, longer-term inflation expectations are well-contained and should remain so if the Fed does its job, namely, to keep inflation under control. Given the Fed's commitment to do exactly that, I am optimistic about the long-term outlook for inflation and think it is likely to remain within a range that, in my opinion, is consistent with price stability.

TIE: One of the recurring themes at the Fed is that companies for quite a while have been saying they're seeing price pass-throughs. Yet the data on inflation are hardly conclusive. The core PCE deflator sits at 1.6 percent. Are you losing confidence in anecdotal evidence? Or are we looking at the wrong data?

Yellen: It's true that the core PCE price index has risen only 1.6 percent over the last twelve months. But over the last three months it's up 2.2 percent--substantially more. We see the same pattern in the core CPI, which is up 2.2 percent over the last twelve months and 2.6 percent over the last three months. I believe we are seeing this pattern of rising core inflation for the reasons I mentioned: pass-through of energy, raw materials, and transportation cost increases into core consumer prices. This is consistent with the anecdotes. Businesses are broadly affected by these cost increases and our contacts tell us that they are having increasing success in passing these cost increases along. But, as I mentioned, I do not see this as alarming. The increase in inflation should be temporary as long as inflation expectations, which influence wage and salary bargaining, remain well contained. That, in turn, comes down to whether or not the Fed can be counted on to do its job and I think it certainly can. Productivity and compensation growth are the drivers of unit labor costs, which are the main determinants of inflation over the medium term. Structural productivity growth and compensation wage growth both look good in spite of the uptick in core inflation.

TIE: Are you at all worried about oil prices staying at the $50 per barrel level?

Yellen: Well, oil prices have continued to surprise market participants on the upside and, at this point, higher oil prices are expected to persist over the next several years. Just a year ago, the futures markets were forecasting that oil would be selling for $30 per barrel at the end of 2006. The forecast is now for oil over $50 per barrel at the end of 2006--a very large change in the outlook.

Oil is not as important in the U.S. economy as it was back in the 1970s--we're far more energy efficient. And oil prices, in real terms, are still below the peaks reached in the 1970s. But higher oil prices do drain consumer purchasing power and hit businesses on the bottom line. I think the decline in consumer confidence and weakness in consumer spending we've seen recently are probably related to the spike in gasoline prices although, as I...