The future of the federal funds rate is “necessarily uncertain,” according to Janet Yellen.

“The future path of the federal funds rate is necessarily uncertain because economic activity and inflation will likely evolve in unexpected ways,” the Federal Reserve Board chair said in a speech to The Economic Club of New York on Tuesday. “For example, no one can be certain about the pace at which economic headwinds will fade. More generally, the economy will inevitably be buffeted by shocks that cannot be foreseen. What is certain, however, is that the Committee will respond to changes in the outlook as needed to achieve its dual mandate.”

In December, the Federal Open Market Committee (FOMC) raised the target range for the federal funds rate, the Federal Reserve’s main policy rate, by a quarter of a percentage point. Since then, the FOMC has remained rather dovish in its January and March meetings.

As shown in those meetings, the pace of rate increases is now expected to be somewhat slower from what was originally projected in December.

The median of FOMC participants’ projections for the federal funds rate is now only 0.9% for the end of 2016 and 1.9% for the end of 2017, both half a percentage point below the December medians.

Despite this change in projections, Yellen emphasized during her speech that the medians of the individual projections for economic growth, unemployment and inflation made by all of the FOMC participants for its March meeting are little changed from December.

She also said the FOMC continues to expect further labor market improvement and a return of inflation to its 2% objective over the next two or three years, consistent with data over recent months.

“This forecast is not a plan set in stone that will be carried out regardless of economic developments,” Yellen told the crowd gathered in New York. “Instead, monetary policy will, as always, respond to the economy’s twists and turns so as to promote, as best as we can in an uncertain economic environment, the employment and inflation goals assigned to us by the Congress.”

Some of the headwinds that continue to restrain the U.S. economy, according to Yellen, include weak foreign activity, dollar appreciation, a pace of household formation that has not kept up with population and income growth and so has depressed homebuilding, and productivity growth that has been running at a slow pace by historical standards since the end of the recession.

“If these headwinds gradually fade as I expect, the neutral federal funds rate will also rise, in which case it will, all else equal, be appropriate to gradually increase the federal funds rate more or less in tandem to achieve our dual objectives,” Yellen said.

Beyond these headwinds, Yellen went into detail about four specific risks that she said could “cloud” the Fed’s current outlook:

 Global Growth

1. Global growth, which Yellen said was significantly influenced by developments in China.

“There is a consensus that China’s economy will slow in the coming years as it transitions away from investment toward consumption and from exports toward domestic sources of growth,” Yellen said. “There is much uncertainty, however, about how smoothly this transition will proceed and about the policy framework in place to manage any financial disruptions that might accompany it.”

 These uncertainties were heightened by market confusion earlier this year over China’s exchange rate policy.

Weaker foreign economic growth, which is expected, would restrain U.S. economic activity, according to Yellen. However,  she added that the effects of slow global growth have been partially offset by the “downward revisions to market expectations for the federal funds rate that in turn have put downward pressure on longer-term interest rates, including mortgage rates, thereby helping to support spending.”

“I anticipate that the overall fallout for the U.S. economy from global market developments since the start of the year will most likely be limited, although this assessment is subject to considerable uncertainty,” she said.

 Commodity prices

2. Prospects for commodity prices, particularly oil.

“For the United States, low oil prices, on net, likely will boost spending and economic activity over the next few years because we are still a major oil importer,” she said. “But the apparent negative reaction of financial markets to recent declines in oil prices may in part reflect market concern that the price of oil was nearing a financial tipping point for some countries and energy firms.”

For countries that are reliant on oil exports, Yellen said that declines in oil prices could result in a sharp cutback in government spending. And, for energy-related firms, she said it could mean “significant financial strains and increased layoffs.”

“In the event oil prices were to fall again, either development could have adverse spillover effects to the rest of the global economy,” she said.

 Inflation

3. There have been signs that inflation expectations may have drifted down, although Yellen called these signs “far from conclusive.”  

If inflation expectations have gone down, Yellen said, “the return to 2% inflation could take longer than expected and might require a more accommodative stance of monetary policy than would otherwise be appropriate.”

According to Yellen, market-based measures of longer-run inflation compensation have fallen noticeably over the past year and half, although they have recently moved up modestly from their all-time lows. However, there is also analysis carried out at the Fed and elsewhere that suggests that the decline in market-based measures of inflation compensation has “largely been driven by movements in inflation risk premiums and liquidity concerns rather than by shifts in inflation expectations,” Yellen said.

In December, the FOMC anticipated that inflation would remain low in the near term due to the drag from lower prices for energy and imports. Since then, those transitory effects faded, and the FOMC now expects inflation to move up to 2% over the medium term, provided the labor market improves further and inflation expectations are stable.

“This assessment still seems to me to be broadly correct,” Yellen said.

Is the Fed underestimating inflation?

4. Risk that the Fed is underestimating the speed at which inflation will return to its 2% objective.

“Economic growth here and abroad could turn out to be stronger than expected, and, as the past few weeks have demonstrated, oil prices can rise as well as fall,” Yellen said. “More generally, economists’ understanding of inflation is far from perfect, and it would not be all that surprising if inflation was to rise more quickly than expected over the next several years. For these reasons, we must continue to monitor incoming wage and price data carefully.”

— Check out El-Erian: Yellen Says What Markets Want to Hear on ThinkAdvisor.