HIGHLIGHTS-Fed chief Yellen's Q&A testimony before House committee

WASHINGTON, July 15 (Reuters) - The following are highlights of Federal Reserve Chair Janet Yellen's question-and-answer session on Wednesday before the U.S. House Financial Services Committee, where she delivered the central bank's semi-annual monetary policy report to Congress.

YELLEN ON HOW THE ECONOMY NOW "NEEDS" HIGHER RATES:

"I would say ... our economy is in a much beter state. Low interest rates have facilitated it, and a decision on our part to raise rates will say, 'No, the economy doesn't stink.' We're close to where we want to be, and we now think the economy can not only tolerate but needs higher rates. So there have been headwinds, and we've tried to use monetary policy to overcome them."

YELLEN ON COMMUNITY BANKS:

"Community banks are really vital to local economies. It is something we are very focused on at the Federal Reserve. We want to see community banks thrive and know that for many different reasons, this is a very difficult environment for community banks.

"The slow pace of economic growth and recovery that we have had, the low interest environment is squeezing their margins and the regulatory burdens that they face have been really quite high and they're struggling with it.

"We are looking at the way that we supervise community banks to do everything within our power to reduce the regulatory burdens and I could give you a list of things that we are doing to try to minimize the burden- more offsite exams, more special tailoring of our exams to the risk profile of the banks."

YELLEN ON CONSEQUENCES OF GROWING FEDERAL DEBT:

"In the years ahead if deficits aren't addressed and become very large they will put pressure on the economy that - not right now, but in future years - likely will cause us to have higher levels of interest rates than we otherwise would have, diminished levels of investment and productivity growth in this economy. We will have to offset those forces by having a tighter monetary policy. But we're not in that situation now."

YELLEN ON LONG-TERM OUTLOOK FOR NATION'S DEBT:

"Like my predecessor, I believe the nation faces a very serious debt problem in the years ahead. At the moment... mainly because of congressional actions and those by the administration (we) have succeeded in lowering deficits to the point where over the next several years the debt-to-GDP ratio is stable. But over time, under CBO projections as the population ages and especially as health-care costs rise above trend, as has been historically typical, the country will face an unsustainable debt path in which the debt-to-GDP ratio rises. That requires further action - that's mainly related to retirement programs, to Social Security and even more importantly, to Medicare and health care cost trends.

"We've known about this for decades and there remains a need for action on this front."

YELLEN ON PUERTO RICO:

"This isn't a matter in which I have an opinion. It's something the Federal Reserve can't and shouldn't be involved in. I think it's appropriate for Congress to consider what's best to do in this case.

What we have been doing is obviously monitoring developments in Puerto Rico, which economically are very difficult. We are looking to see, are there risks that are being transmitted to the broader municipal market and we are not seeing signs of contagion."

YELLEN ON FOMC'S ROLE IN INVESTIGATION OF LEAK:

"We've said that we plan to give (the documents) to you as soon as we're able to do so and not compromise an open criminal investigation. We want to see this investigation succeed.

"The FOMC has in place a clear set of rules for their part to be followed when there are allegations of a leak. They call for a review of the incident by the general counsel and the FOMC secretary who have described to you how that review took place.

"Before his review was complete he (the general counsel) was informed by the IG (LSE: IGG.L - news) that the IG had undertaken his own investigation and therefore the IG was already looking at it before it was necessary for him to make a decision... The IG was already involved."

YELLEN ON INTEREST RATES:

We are not going to raise rates if we think it is going to tip the economy into a recession. We will raise rates because we believe the economy is strong enough that it is appropriate to have higher rates to meet the objectives that have been assigned by Congress.

YELLEN ON LABOR MARKET PROGRESS, 'TENTATIVE' WAGE GROWTH:

"Monetary policy has been aimed at trying to achieve a strong recovery in the job market. And while we are not there yet, I believe we've made substantial progress. As the economy improves and the labor market gets stronger, I would expect to see the growth of wages pick up over time, and at this point I think we're seeing at least some first tentative signs that wage growth is increasing."

YELLEN ON SYSTEMICALLY IMPORTANT FINANCIAL INSTITUTION (SIFI) DESIGNATION:

"FSOC reviews every single year, the designations of firms and considers whether or not they are appropriate or if they are no longer appropriate. And firms that are designated are given very detailed material to enable them to understand the basis of the designation."

YELLEN ON WAITING LONGER TO HIKE RATES:

"If we wait longer (to raise rates) it certainly could mean that when we begin to raise rates we might have to do so more rapidly. So an advantage to beginning a little bit earlier is that we might have a more gradual path of rate increases."

YELLEN: NO DECISION ON TIMING OF RATE HIKE:

"We have no judgment at this point about the appropriate date to raise the federal funds rate. Our judgment about this will depend on the unfolding economic developments and how they affect our forecasts."

YELLEN ON EFFECTS OF GREECE, OTHER INTERNATIONAL DEVELOPMENTS:

"Of course we continue to watch these global developments unfold and we will in the coming months. Were we to judge that these developments did create substantial risks or were changing the outlook in some notable way, then the change in the outlook is something that would affect monetary policy."

YELLEN ON PROBE INTO OCT. 15, 2014 MARKET MOVES:

"We just don't have a conclusion on what happened in the Treasury market at this point. Regulation could have contributed in some way to this, but there are many other things going on as well."

YELLEN ON INCOME INEQUALITY:

"The predatory pricing, rising inequality...the impact it has on African Americans and disadvantaged groups is something that greatly concerns me and I think it is of tremendous concern to all Americans...

"We are responsible for supervision of financial institutions to make sure that they adhere to fair lending practices and we test regularly in our consumer compliance exams to make sure that the firms that we supervise are abiding by Congress's rule pertaining to equal credit opportunity and to make sure that there are no unfair credit practices that are being directed toward minorities or toward any Americans..."

"We don't have the tools to be able to address the structural unemployment across groups, but a stronger economy generally really does tend to be beneficial to all Americans and that's what we are working towards."

YELLEN ON WHETHER DODD-FRANK ENSHRINED 'TOO BIG TO FAIL':

I don't believe that Dodd-Frank enshrined 'too big to fail.' First (Other OTC: FSTC - news) of all, it directed us to increase the safety and soundness of financial institutions, and particularly those that are most systemic. So it gave us tools to raise capital and liquidity, to impose capital surcharges on those firms it would deem most systemic, to use stress-testing as a methodology, to make these firms much less likely to fail, and the amount of capital and liquidity has increased massively since the crisis.

YELLEN ON RESISTANCE TO RULES-BASED MONETARY POLICY:

"I don't agree that a rules-based policy is a better way to go. There's not a single central bank in the world that follows a rule that would rely on only two variables."

"I think we need a systematic policy. But I would strongly resist agreeing to follow any rule where the stance of monetary policy depends on only the current readings of two economic variables, which is what your reference rule relies on." (Compiled by Jonathan Spicer, Elvina Nawaguna and Megan Cassella; Editing by Andrea Ricci)