Prospects for core U.S. inflation look favorable over the medium term but the Federal Reserve (search) must ensure price pressures from energy costs and the labor market do not get out of control, San Francisco Fed President Janet Yellen (search) said on Tuesday.

Continuing the tough talk that has characterized Fed officials' recent comments, Yellen suggested the central bank would continue its policy of gradual interest-rate increases to head off inflation pressures.

"One option that clearly is not on the table is allowing an unacceptable rise in inflation," she said in remarks to a community leaders' luncheon, repeating comments she made on Sept 27.

While Yellen said there is no evidence so far that rising energy prices are feeding into wage inflation, she warned the U.S. could risk a repeat of the 1970s-style wage-price spiral without appropriate monetary policy.

"It thus made sense to me to continue the gradual removal of policy accommodation" with a September rate hike, Yellen said.

The central bank's policy-setting Federal Open Market Committee (search) has raised rates at 11 consecutive meetings dating back to June 2004 in a bid to head off inflation pressures, pushing the fed funds rate to 3.75 percent from a 1958-low of 1.0 percent.

Yellen, who will be a voting member of the FOMC in 2006, noted that a range of 3.5 percent to 5.5 percent was "reasonable" for a neutral fed funds rate -- one that neither promotes nor stymies economic growth.

"This suggests a presumption that the rate (now at 3.75 percent) will need to be raised further," and financial markets appear to be expecting a peak of about 4.5 percent in the key lending rate, Yellen said, without endorsing that view.

"As the federal funds rate nears a reasonable estimate of the neutral rate, monetary policy must become more and more dependent on incoming data," she added.

KATRINA IMPACT

Two recent reports from the Labor Department have shown surging energy prices in the wake of Hurricane Katrina have already pushed up inflation. U.S. consumer prices soared 1.2 percent last month, the largest jump in 25 years, while wholesale prices climbed 1.9 percent.

Yellen said the U.S. economy was still being affected by the summer hurricanes and would see a "noticeable dent" in growth and employment in the second half of 2005 before growth picks up in the first half of 2006 and returns to more of a trend level in the second half of next year.

Documents released on Tuesday by the U.S. central bank showed five of the 12 regional Federal Reserve banks wanted to hold the discount rate steady in the immediate aftermath of Hurricane Katrina.

Board directors of the five -- Cleveland, Atlanta, St Louis, Dallas and San Francisco -- wanted to keep the discount rate, which governs the cost of borrowing for banks from the Fed system, at 4.5 percent until more was known of the impact the storm's destruction would have on U.S. growth.

"Some directors noted ... the damage and disruption caused by the hurricane had prompted them to lower their expectations for economic growth for the remainder of the year," minutes of the discount rate meetings showed.

Separately, New York Fed President Timothy Geithner said on Tuesday the challenge for the Fed after the retirement of Chairman Alan Greenspan in January is to keep inflation and inflation expectations in check. He noted that the achievement of Greenspan and his predecessor, Paul Volcker, on inflation had contributed to economic stability.

"That legacy is our principle challenge" after Greenspan departs, Geithner said in response to a question after a speech in New York.

Geithner also said the increased complexity of financial systems reduces the vulnerability of individual firms to risk, but adds to uncertainty over how well the financial system would respond to a major shock.

"The developments have contributed to what seems to be a significant improvement in the overall stability and resilience of the U.S. financial system by reducing the vulnerability of individual institutions to a broader range of potential shock," Geithner said in prepared remarks to a banking group.

"They may also, however, add to uncertainty about how well the system might function in the context of a major systemic shock," he said.