New York Federal Reserve Bank President William Dudley Thursday said recent soft economic data, mostly due to inclement weather in recent months, will not be enough to halt the Fed’s steady reduction in the size of its monthly asset purchases.
Dudley, who as vice chair of the policymaking Federal Open Market Committee has a permanent vote, said a significant change in the outlook – for better or for worse – would be needed to alter the central bank’s approach to winding down its now-$65 billion a month in bond buying.
Despite the significant impact that weather conditions have had on economic activity so far in 2014, Dudley said at a Wall Street Journal breakfast event that the economic outlook would have to change “in a material way” to bring about an alteration in the pace adopted by the Fed in winding down the program.
A first quarter GDP weakened by the severe winter does not qualify as a fundamental change in the outlook, he said. On the other hand, if economic growth were to accelerate beyond expectations – by say 5% – or not grow at all, “those would be the kind of changes in the outlook that I think would warrant changing the pace of taper,” Dudley said.
Still, he added, “the threshold is pretty high to change it.”
The market now has certainty that the Fed will reduce the program in $10 billion increments at each FOMC meeting, Dudley said, with the only question being what happens at the October gathering when the central bank is down to buying $15 billion a month in large scale assets.
He stressed that the taper path remains data-dependent, but a change in policy would require bad data that changes the economic outlook significantly.
He also stressed that there is no “strong imperative” for the Fed to shrink its balance sheet, and that its portfolio will stay very large “for quite a while.” It is “highly likely,” he added, that the Fed’s reinvestment of interest received from its MBS holdings will continue very close to “liftoff” when the first hike in short term interest rates occurs.
Dudley said his assessment is that the labor market still has “a significant amount” of slack, meaning “we have a long time to go before when we actually have to think about raising short-term rates, in my opinion.”
The general view in the financial markets is for the first interest rate hike to occur in the second half of 2015, and Dudley said he believes the markets’ expectations “are appropriate based on what we know today … the Fed thinking and the market thinking, I think, is very closely aligned currently.”
The economy is “pretty far away” from the point when it can be said there is no more slack in the jobs market, Dudley said.
The FOMC next meets on March 18-19, and the spotlight is expected to be on its vow to keep interest rates low so long as unemployment is above 6.5% and inflation does threaten to exceed 2.5%. The Fed is under pressure to yet again revise its forward guidance, given that the unemployment rate in January fell to 6.6%, and could fall further when February’s employment data is released Friday.
Dudley described the 6.5% threshold as already being “a little obsolete” given how close the economy already is to that mark. So it no longer provides much value in terms of the Fed’s communications, “so my personal view is this is probably a reasonable time to revamp the statement to take out that 6.5% threshold because it’s not really providing any great value.”
The New York Fed chief said he would prefer to make the change before the 6.5% unemployment threshold is reached, rather than after, in order to avoid any confusion.
As for what would replace the threshold, Dudley indicated a preference for the approach utilized by the Bank of England – which is more qualitative in nature. “We have to look at a broad set of labor market conditions rather than one single indicator,” he said.
He highlighted the difficulty in interpreting labor market conditions right now, as there has been a sharp drop in unemployment but mostly due to a drop in the labor force participation rate. This in turn is a mixture of changes in demographics and an increase in discouraged workers, Dudley said.
“We would expect that some of those discouraged workers are going to come back into the workforce as the labor market improves,” he continued, “but we don’t really have a really good sense of how much fits in which category.”
Dudley noted positive signs for the economy this year, as the fiscal drag that was a big factor last year is “definitely lessening,” household deleveraging is “far along” and real incomes are starting to improve.
“So it seems to us that the economy should do better in 2014 than 2013,” Dudley said.
One question mark is the weather, with the extreme winter conditions likely to make assessing economic data over the near term “a little more difficult” as it has depressed economic activity in the current quarter, he added.
“For myself I think it’s a working assumption that the weather is probably going to cut maybe a half to one percent off the annualized growth rate in the first quarter,” Dudley continued, “so first quarter (growth) is probably going to be less than 2% in terms of annualized growth.”
As the nation moves into the Spring months, however, Dudley said he expects to see the firmer growth in the second quarter as the weather effects dissipate. He said his longer term economic forecasts have not changed very much, saying his sense is that the U.S. economy is on a 3% growth trajectory.
This should be enough to generate payroll gains that result in continued, gradual improvement in the labor market, he said.
As for price stability, Dudley said he is not worried about the low level of inflation so long as the outlook for growth is good.
Some of the above is due to a weak compensation trend in the labor markets, he said, and the expectation is for inflation to drift up towards the FOMC’s 2% objective as transitory factors fade.
Regarding the ongoing tensions in Ukraine, Dudley said it’s too soon to have view on how big the impact is going to be – “whether it’s going to be a very modest thing for the global economy or a more substantive thing.”
Dudley said he does not see much excess in financial markets, with nothing that is “substantive enough” to cause great concern.
As for the overnight reverse repo facility being tested by the New York Fed as a possible monetary policy tool, Dudley said it is “too soon to make any definitive judgment about whether we are going to use reverse repos in a fundamental way to alter the monetary policy framework because we are still in the testing phase to see how they work.”
The Fed is collecting information to see how effective a tool the above is in putting a floor under money market rates,” he said. “If we find that the tool works well, this would open up another option in terms of the monetary policy framework going forward.”
“We could use, potentially, the reverse repo facility to have a floor-based system – where the reverse repo rate actually sets a floor on rates and there’s a lot of excess reserves in the system,” Dudley said, although it is too soon to decide “if that’s the right way to go.”