Fed's Yellen says U.S. recovery incomplete, defends loose policy

By Howard Schneider and Michael Flaherty WASHINGTON, (Reuters) - The U.S. economic recovery remains incomplete, with a still-ailing job market and stagnant wages justifying loose monetary policy for the foreseeable future, Federal Reserve Chair Janet Yellen told a Senate committee on Tuesday.

In a strong defense of the central bank's current stance, Yellen said that early signs of a pickup in inflation aren't enough for the Fed to accelerate its plans for raising interest rates, a move currently expected in the middle of next year.

That could change, with interest rates rising sooner and faster, if data show labor markets improving more quickly than expected, she said.

But as it stands, "although the economy continues to improve, the recovery is not yet complete," Yellen said in semi-annual testimony before the Senate Banking Committee, repeating her focus on lagging labor force participation and weak wage growth as key to any conclusions about the economy's health.

"Too many Americans remain unemployed," Yellen said.

Yellen presented a broad overview of an economy still in transition from the 2007-2009 economic crisis. In an accompanying report, the Fed said its balance sheet would top out at $4.5 trillion when its bond-buying program ends in October, a sign of how much stimulus the central bank has had to unleash to support the economy.

With another $2.6 trillion held in reserve by banks, the report said it "will not be feasible" for the Fed to rely on the traditional Fed Funds market to manage interest rates - a judgment implicit in its recent work on new interest rate tools.

In her remarks, Yellen said the economy continues to generate jobs and steady growth. But she said Fed policymakers currently expect their preferred measure of inflation to stand at between 1.5 percent and 1.75 percent for 2014, short of the central bank's 2 percent target. The housing market remains weak, Yellen said, and business investment less than hoped.

Thriving equity and security markets have raised concerns of a possible bubble, but Yellen said that the values of stocks, bonds and other assets "remain generally in line with historic norms."

Fed chairs are mandated by law to report to Congress twice a year on monetary policy, and the hearing on Tuesday is Yellen's second such appearance. Her first turned into a marathon grilling about her philosophy and views of the economy.

The Fed faces a complex agenda as it weans the U.S. economy from the massive stimulus programs put in place to fight the financial crisis.

Economic data has kept Fed policymakers relatively upbeat that the economy will make steady progress towards the central bank's goals.

But there is also the potential for serious division.

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Some policymakers worry the Fed is falling behind the curve on rate hikes and that Yellen is taking too much of an impromptu approach to the interest rate decision. In her prepared testimony, she held firm to her view that low labor force participation and other labor market statistics are evidence of slack that needs to be absorbed by stronger job growth, not just a sign of unavoidable demographic change.