AMHERST, Mass.—Federal Reserve Chairwoman Janet Yellen argued the case for raising short-term interest rates later this year, effectively lobbing a warning to skittish financial markets that last week's decision to keep rates near zero wasn't a shift toward an interminable delay of liftoff.
Ms. Yellen, setting out to build a case like a prosecutor giving a closing argument, presented a 40-page speech in a cavernous auditorium at the University of Massachusetts in Amherst. Thursday's speech included 40 academic citations, 35 footnotes, an appendix and nine graphs projected to an audience of about 1,800 students and professors on a large screen.
The presentation was momentarily overshadowed when the Fed leader, 69 years old, faltered near the end of the 50-minute presentation, pausing for a long stretch, stumbling over some words and coughing. An individual in attendance approached Ms. Yellen to ask if she was all right and offered to help her off stage as she concluded. Ms. Yellen walked off on her own.
The Fed blamed Ms. Yellen's stumble on dehydration after a long day and long speech under bright lights. She was seen by local emergency-medical personnel and resumed her schedule afterward, including a work-related dinner on campus, a Fed spokeswoman said.
Central to the argument she set out to establish before wobbling is a belief that slack in the economy has diminished to a point where inflation pressures should start to gradually build in the coming years. Ms. Yellen argued those pressures aren't asserting themselves yet, because a strong dollar and falling oil and import prices are placing temporary downward pressure on consumer prices. As those headwinds diminish, she predicted, inflation will gradually rise.
The Fed needs to get in front of this, she said, and also prevent speculative forces in financial markets that could lead to "inappropriate risk-taking that might undermine financial stability," she said in the prepared text of her comments.
"It will likely be appropriate to raise the target range of the federal-funds rate sometime later this year and to continue boosting short-term rates at a gradual pace thereafter as the labor market improves further and inflation moves back to our 2% objective," Ms. Yellen said.
The central bank has been warning for months that it expects to start raising interest rates this year as officials see more labor-market improvement and become confident inflation will rise toward their 2% target over time. The Fed cut its benchmark short-term interest rate, known as the federal-funds rate, to near zero in December 2008 and has held it there since to support the economy.
Investors, however, have come to doubt the timing, especially after the Fed decided last week not to act after weeks of buildup for a possible rate increase this month.
In futures markets before the speech, traders placed just a 35% probability on a Fed rate increase before year-end, according to the Chicago Mercantile Exchange. Uncertainty about the Fed's plans has led to volatility in financial markets, with the Dow Jones Industrial Average down 3.2% since last week's meeting.
A part of the market uncertainty was some confusion about where the Fed leader herself stands. Before her postmeeting news conference last week, Ms. Yellen hadn't spoken publicly since July.
"She made the case for why rates should start moving up soon. She hadn't done that yet, and I believe investors will welcome the additional clarity," said Roberto Perli, an analyst at the research firm Cornerstone Macro.
The Fed's delay last week has already reverberated around the world, leading many central banks to take a turn toward easier interest-rate policies.
This week, central banks in Norway, Taiwan and Ukraine lowered interest rates. The central bank of India appears on track to cut rates, too. Meantime, investors have piled into European bonds, anticipating the European Central Bank would launch a new bond-purchase program to boost the eurozone economy and inflation. Other central banks that might have responded to a Fed rate increase with upward moves of their own—including those in Mexico and Turkey—instead this week opted to keep rates on hold.
"It is very hard for most other central banks to operate independently of the Fed, especially in emerging markets," David Hensley, an economist at J.P. Morgan, said before Ms. Yellen's speech. "By delaying liftoff, the Fed perhaps unwittingly opened the door to easier monetary policy around the world for a while."
Ms. Yellen's comments late Thursday might now alter that calculus. At their meeting last week, Fed officials emphasized the role that a strong dollar and economic slowdown in emerging markets played in causing uncertainty about the economic outlook and delaying a rate increase.
In her comments Thursday, Ms. Yellen emphasized the domestic economy and sought to look past headwinds from abroad.
"Some slack remains in labor markets, and the effects of this slack and the influence of lower energy prices and past dollar appreciation have been significant factors keeping inflation below our goal," she said. "But I expect that inflation will return to 2% over the next few years as the temporary factors weighing on inflation wane."
Ms. Yellen underscored the risks of waiting too long to raise rates, something she touched on in congressional testimony earlier this year but hasn't drawn out in a speech.
Fed policies affect the economy with a lag—households and businesses take time to make decisions about taking out new loans or issuing bonds even after the Fed starts adjusting rates on loans. If it waits too long, Ms. Yellen said, the Fed might end up having to raise rates abruptly to stop the economy from overheating. Moving rates up that way, in turn, could push the economy back into recession or send financial markets tumbling.
"The more prudent strategy is to begin tightening in a timely fashion and at a gradual pace, adjusting policy as needed in light of incoming data," she said.
Ms. Yellen's remarks, delivered in a theater in the UMass Amherst Fine Arts Center, echoed those that other Fed officials have made in the days following last week's meeting. Many have said they expect to move rates up this year. The comments also reflected some themes that came out of the Fed's decision last week; 13 of 17 officials projected the Fed would raise rates this year.
Still, the repeated delays—and the Fed's focus last week on threats to the economy from China and the stronger dollar—could lead to some confusion about the central bank's decision-making.
"Sounds like a talk she would have given to explain why [Fed] raised rates last week!" Laurence Meyer, co-founder of Macroeconomic Advisers, a consulting firm, and a former Fed governor, said in an email exchange after her comments were released.
In making its call on interest rates, the Fed is relying on uncertain models that predict short-run trade-offs between unemployment and inflation. As the jobless rate falls, theory holds, upward pressure on wages and inflation could build. But the precise level of unemployment where this pressure emerges is unknown and tends to vary, leaving the Fed in the dark about the right time to move. Some economists doubt such a relationship—known in academic circles as a "Phillips curve" after the late economist A.W. Phillips—even exists.
Even though Ms. Yellen indicated she wanted to start raising rates, she also indicated that she has little desire to move aggressively enough to slow the economy down much. The Fed leader said she wouldn't mind seeing the jobless rate, which was 5.1% in August, fall even further.
"Attracting discouraged workers back into the labor force may require a period of especially plentiful employment opportunities and strong hiring," she said. "Similarly, firms may be unwilling to restructure their operations to use more full-time workers until they encounter greater difficulty filing part-time positions."
Other uncertainties weigh on Ms. Yellen, which could throw the central bank off course. These include shifting expectations among households, businesses and investors about future inflation. In the long run, she noted, the public's expectation about where prices are heading matter more than unemployment in determining the level of inflation.
The Fed is now confronted with conflicting signals on the path of inflation expectations. While household surveys suggest expectations are stable, movements in Treasury inflation-protected securities markets suggest expectations among investors are drifting lower. Fed officials have tended to dismiss the bond movements this year as idiosyncratic. But the persistence of moves in TIPS markets makes Ms. Yellen cautious about moving rates aggressively.
"The decline in inflation compensation [in bond markets] over the past year may indicate that financial market participants now see an increased risk of very low inflation persisting," she said. "Although the evidence, on balance, suggests that inflation expectations are well anchored, policy makers would be unwise to take this situation for granted."
A shift in these or other variables, Ms. Yellen said, could lead the Fed to choose a different path for rates.
Write to Jon Hilsenrath at jon.hilsenrath@wsj.com and Ben Leubsdorf at ben.leubsdorf@wsj.com
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