WASHINGTON (MarketWatch) -- Commercial real estate is the new Achilles heel for the U.S. banking sector, said Janet Yellen, the president of the San Francisco Federal Reserve Bank on Tuesday.

"The next area of significant vulnerability for the banking system, particularly for community and regional banks with real estate concentrations, is income-producing office, warehouse and retail commercial property," Yellen told a bankers conference in Idaho.

"Our biggest concern now is with maturing loans on depreciated commercial properties," Yellen said.

Borrowers are going to have trouble coming up with additional equity to refinance the properties, Yellen said. And underwriting and pricing must be adjusted to reflect current market conditions, she said.

Heartbreak of Foreclosure for Hotels

"The economic forces hammering commercial property are unlikely to reverse anytime soon," Yellen said.

The sector is just one more example of regulatory failure. Washington has been talking to banks about commercial real estate for years with little to show for it.

Many banks failed to implement risk management steps outlined by regulators in 2006, Yellen said.

Yellen urged banks to "plan for the worst and use caution." But they should continue to make loans to creditworthy borrowers.

Inflation

Concern that the massive federal budget deficit will cause inflation is misplaced, Yellen said.

Deficits don't cause inflation, she said. Instead, the worry is that they will cause higher interest rates.

"Right now, private investment spending is extremely weak, so financing for the large federal deficits is readily available. But once private spending recovery, the competitions for funds between the government and private sectors could drive interest rates up," Yellen said.

"I expect core inflation to remain below 2% for several more years," Yellen said.