Current U.S. interest rate policy should promote a further drop in inflation although risks are still skewed toward higher prices, San Francisco Federal Reserve President Janet Yellen said on Thursday.

Upside risks to inflation continue to be present, given the possibility that labor markets are somewhat tight, Yellen said in remarks prepared for delivery by videoconference to a risk management conference in Singapore.

However, it is also essential that policy retain considerable flexibility in responding to emerging data.

The Federal Open Market Committee last week left its benchmark overnight lending rate at 5.25 percent for an eighth consecutive meeting.

Yellen, who is not a voting member of the FOMC in 2007 said the current Fed rate avoided the risk of an economic downturn but should be high enough to produce some slack in the goods and labor markets.

In her first extensive comments on the economy since April, the Fed's 12th District President cited continued tightness in the labor market and a recent slowdown in productivity growth as items keeping inflation risks slanted to the upside.

The low U.S. unemployment rate of 4.5 percent in May and continued brisk job creation were a puzzle in the face of recent subpar growth, Yellen said.

Even so, I expect to see some further improvement in core inflation over the next year or two, she said.

The closely watched core personal consumption expenditures

(PCE) price index advanced by 1.9 percent in May from a year ago, data showed on June 29. That put the index at its lowest year-over-year level since March 2004.

Yellen termed a recent brisk decline in core inflation, or prices stripped of food and energy costs, heartening, but echoed last week's FOMC statement, released before the PCE data, in saying the trend has yet to be sustained.

Inflation expectations in the U.S. continue to be well anchored, a reflection of the Fed's credibility with the public about its commitment to keeping inflation low and stable, Yellen said.

She forecast moderate U.S. growth through the end of 2008, with housing likely to be less of a drag going forward even though tighter credit conditions and higher mortgage foreclosures could still deepen the housing downturn.

From the standpoint of monetary policy I do not consider it very likely that developments related to subprime mortgages will have a big effect on overall U.S. economic performance, said Yellen.

MARKETS IN SYNC?

Yellen said financial markets, which now imply steady Fed rate policy through year-end, have become more closely aligned with the central bank's own views than when futures prices suggested the Fed would need to slash rates.

I suspect that the markets and the Committee have become more closely aligned, sharing the view that growth in the U.S. is, and is likely to remain, healthy, she said.

Short-term rate futures currently show less than a 10 percent chance that the Fed will trim rates in 2007.

Still, a fresh risk to the U.S. and global economy could still emerge from a possible shift in risk perceptions in international financial markets, she said.

There are now numerous indications that risk premiums are notably low, including the unusually low term-premium on long-term bond rates, Yellen said.

Yellen warned that investors may be underestimating substantial exchange rate risk created by the popular carry trades, where investors borrow at lower rates in one currency and invest in higher-yielding bonds in another.

A shift in risk perceptions would tend to push longer-term rates and credit spreads up, restraining demand worldwide, she warned.

Inflation