But Yellen stressed that any rate increases would likely be very gradual.
The Fed has kept its benchmark rate at a record low near zero for more than six years. Yellen said in a speech in San Francisco that the time to start raising the rate could occur "sometime this year," though she said the time hasn't yet arrived.
In her speech, Yellen said that the Fed's first move would depend on how the economy performs. She said that when the Fed does start raising rates, policymakers expect the increases to be "rather gradual" for the next few years.
Yellen said Japan's experience over the past 20 years argues for a cautious approach. Over that time, Japan has struggled with anemic economic growth as well as deflation — a period of falling prices that's been hard for its policymakers to overcome.
Yellen said a key reason for a gradual approach to higher rates is that the danger of raising them too fast is greater than the risk of doing so too slowly. If the Fed were to tighten loan rates too quickly, the economy could stall and, with rates still relatively low, the Fed would have little room to cut them.
But she did say that taking a "gradualist approach" to raising rates carries its own risks. One is the possibility that it might undermine the Fed's credibility as an inflation fighter and could risk instability in financial markets by allowing an excessive buildup in borrowing.
"At this point, the evidence indicates that such vulnerabilities do not pose a significant threat, but the (Fed) is carefully monitoring developments in this area," she said.
Yellen's comments offered an elaboration on signals the Fed sent after its latest policy meeting last week. It said then that it was content to move slowly to raise rates because it wanted to see further improvement in the job market and an increase in inflation levels.
Inflation recently has fallen further below the Fed's 2 per cent target for annual price increases.
On Monday, Fed Vice Chairman Stanley Fischer said in a speech in New York that he expected the central bank to start raising rates sometime this year.
Both Yellen and Fischer stressed the Fed's expectation that rate hikes would be incremental and that the Fed's action would depend on how the economy performs.
Paul Ashworth, chief U.S. economist at Capital Economics, said Yellen's remarks didn't alter his view that the Fed will start raising rates in June, though many other economists foresee no increase before September.
"We still think that sizeable gains in payrolls over the next few months will prompt the Fed to start raising rates in June," Ashworth said.
He predicted that while rate hikes this year would be gradual, the increases would pick up in 2016 as the Fed responds to stronger wage growth and higher inflation.
In its policy statement last week, the Fed said it wouldn't be appropriate to start raising rates until the job market improved further and Fed officials were "reasonably confident" inflation would return to their 2 per cent target.
In her speech, Yellen stressed that Fed officials don't envision raising rates in a predictable way, as they did during the string of 17 quarter-point increases they carried out from 2004 to mid-2006.
Rather, the Fed's policy will evolve as economic conditions do. Rate increases could speed up, slow down, pause or even reverse course depending on the direction of the economy and inflation, she said.
In answer to a question after her speech, Yellen said the Fed was monitoring the rising value of the dollar. She said that while this trend would likely dampen demand for U.S. exports, it could also fuel economic growth in other countries, which, in turn, could boost demand for American products.Suggest a correction