By Ros Krasny
BOSTON, June 6 (Reuters) - The Federal Reserve's second-highest official on Wednesday laid out the case for the U.S. central bank to provide more support to a fragile economy as financial turmoil in Europe mounts.
Janet Yellen, the vice chair of the Fed, cited risks from ongoing housing problems, a weak jobs market and worsening financial conditions in a speech in Boston. Her views carry great weight with Fed Chairman Ben Bernanke, and her comments suggest that the Fed may be close to easing policy again.
Yellen said the U.S. economy is growing at around a 2 percent rate and said the labor market seems to have stalled - and that is before the scheduled year-end expiration of various tax cuts that she said would be another "huge drag" on growth.
"There are a number of significant downside risks to the economic outlook, and hence it may well be appropriate to insure against adverse shocks that could push the economy into territory where self-reinforcing downward spiral of economic weakness would be difficult to arrest," she said.
Her remarks before the Boston Economic Club come a day ahead of congressional testimony by Bernanke, who would be unlikely to take a widely different stance from his respected deputy.
Yellen, who is known as favoring aggressive Fed moves to support growth, laid out a thorough argument on why the economic outlook is darkening and were delivered the same day that several centrist Fed policymakers also expressed mounting concerns.
Yellen said the Fed could buy more bonds to keep rates low or push even further out the date it has given for when to expect the central bank's first interest rate increase. The Fed, which has kept rates near zero percent since December 2008, has already pledged conditionally to keep rates ultra low until at least late 2014.
Fed policymakers at their next meeting, on June 19-20, will assess the effects of recent labor market reports and financial developments on the economic outlook, Yellen said.
"I am convinced that scope remains for the (Fed) to provide further policy accommodation either through its forward guidance or through additional balance-sheet actions," she said.
While both communications tools and bond purchases have limitations and costs, the looming risks make a strong case for the Fed to take precautionary steps to safeguard the economic recovery, Yellen said.
She described recent data as "pretty disappointing" and said the challenge going forward is to make progress on bringing the economy back to full employment. While the average pace of job creation so far this year is consistent with a modest expansion, the disappointing 69,000 new jobs added in May and a rise in the jobless rate highlight the risks, Yellen said.
"Recent labor market reports and financial developments serve as a reminder that the economy remains vulnerable to setbacks," she said.
Asset purchases could take the form either of a fresh round of bond purchases or an extension of the current program exchanging shorter-term securities for longer-term ones, which pushes down longer-term interest rates, she added.
Her comments marked a contrast with the European Central Bank, which dashed hopes on Wednesday it would take immediate action despite a euro zone economy that is under increasing threat.
Tensions in financial markets have risen sharply over the past month after elections in Greece ended in political stalemate and as European leaders struggle to help Spain shore up its banks and rein in its budget deficit. Money has flooded into safe assets, tightening financial conditions and weighing on U.S. growth prospects.
At the same time, recent economic data in the United States, particularly the May jobs report, has been disappointingly weak. Before these latest strains had emerged, Fed policymakers had seemed on track to stay the course.
In making a case for monetary policy insurance, Yellen cited risks that the European sovereign debt crisis could spin out of control.
"The deterioration of financial conditions in Europe of late, coupled with notable declines in global equity markets, also serve as a reminder that highly destabilizing outcomes cannot be ruled out," she said.
U.S. stock index and Treasury futures edged higher in Asian trading and the dollar dipped against a basket of currencies on the prospect of a third round of Fed bond buying, known as quantitative easing.
"This is more dovish than I was expecting," said Adam Button, a currency analyst at Forexlive.com in Montreal. "Yellen has certainly taken a step toward QE3. Yellen's comments are much bolder than those we heard earlier today."
SOFTER TONE
Also on Wednesday, Dennis Lockhart, president of the Atlanta Fed, and John Williams, head of the San Francisco Fed, pointed to Europe's brewing crisis as a main threat to the United States.
"Should it become clear that something resembling my baseline scenario of continued, though modest, growth is no longer realistic, further monetary actions to support the recovery will certainly need to be considered," Lockhart said in Fort Lauderdale, Florida.
Williams, who like Lockhart has a vote this year on the central bank's policy-setting panel, warned in a speech in Bellevue, Washington, that Europe's debt crisis as well as tighter U.S. fiscal policies are "wild cards" for the domestic economy.
"We must also stand ready to do even more if needed to best achieve our statutory goals of maximum employment and price stability," he said.
In addition to maintaining low interest rates, the Fed already has bought $2.3 trillion in long-term securities to stimulate the U.S. economy.