New York Federal Reserve Bank President William Dudley Tuesday said the timing of the central bank’s first interest rate increase will be influenced by the economy’s performance – with faster-than-expected growth bringing the date forward, while disappointing inflation and jobs data would delay action by the Fed.
Dudley also stressed that once the Fed does begin tightening monetary policy, the pace will be “relatively slow,” and dictated by how the economy and financial conditions respond, while making it clear that still too high unemployment would remain the priority even if inflation were to rise “slightly” above the Fed’s 2% objective.
He also advocated not ending the Fed’s policy of reinvesting principal repayments from its mortgage bond holdings until after the first rate hike.
As New York Fed chief, Dudley holds a permanent vote on the policymaking Federal Open Market Committee. He told the audience that, “over the near-term, if circumstances evolve relatively close to my forecast, I would continue to favor gradually reducing the pace of asset purchases by staying on the same glide path of a $10 billion reduction in the monthly purchase pace following each FOMC meeting.”
After the program ends, attention switches to the timing of the first Fed hike in the federal funds rate. The consensus FOMC view is that this will occur sometime next year, and Dudley emphasizes the key role that the economic outlook will play in this decision.
“If the economy is stronger than expected, causing the excess slack in the labor market to be absorbed sooner and inflation to rise more quickly than forecasted, then lift-off is likely to be pulled forward in time,” he said. “If, instead, economic growth disappoints, inflation stays unusually low and the labor market continues to exhibit evidence of considerable excess slack, then lift-off will likely be pushed back in time.”
Dudley said his expectation is that the pace of tightening after the first rate increase will be slow and depend on conditions on the ground. A “somewhat faster pace” might be seen if the impact on financial conditions is mild, he said, while the Fed might adopt a cautious approach if bond yields, for example, where to move sharply higher.
Nevertheless, due to persistent economic headwinds, an aging population, and higher capital requirements for banks, Dudley said that “in terms of the level of rates over the longer-term, I would expect them to be lower than historical averages.”
“Putting all these factors together, I expect that the level of the federal funds rate consistent with 2% PCE inflation over the long run is likely to be well below the 4.25% average level that has applied historically when inflation was around 2%,” he said.
Dudley also addressed the question of how the Fed will likely manage its balance sheet once quantitative easing is over and rate increases begin.
While the portfolio normalization process will be set on autopilot, Dudley called for the FOMC’s plans for mortgage-backed securities reinvestments to be revisited.
The FOMC’s current plans call for an end to reinvestments as the first step in its exit strategy from highly accommodative monetary policy. Dudley argued that, “Ending reinvestments as an initial step risks inadvertently bringing forward any tightening of financial conditions as this might foreshadow the impending lift-off date for rates in a manner inconsistent with the Committee’s intention.”
He also believes that, “Delaying the end of reinvestment puts the emphasis where it needs to be – getting off the zero lower bound for interest rates. In my opinion, this is far more important than the consequences of the balance sheet being a little larger for a little longer.”
As for how the Fed will control money market rates with an outsized balance sheet, Dudley said an extra degree of control will be provided through the overnight reverse repo facility that is currently being tested by the New York Fed.
“Early results suggest that the overnight RRP facility will set a floor under money market rates,” he said.
Regarding the outlook for the economy, Dudley forecasts growth to get back to 3% trajectory for the rest of the year, before strengthening further in 2015. While not concerned about the disappointing first quarter, Dudley cautioned against counting “our chickens before they hatch,” warning that there remains “considerable uncertainty” about the outlook.
“Business fixed investment and housing are two key areas where activity has been disappointing. They need to kick in more forcefully for the economy to grow at an above trend rate for a sustained period,” Dudley said.
While the Q1 contraction in business spending has been “a puzzle,” Dudley said he expects capital spending to pickup.
He also voiced surprised about the recent slowdown in housing market activity, and blamed tight credit conditions for households with poor credit scores, low housing supply, and low housing prices in some markets compared to the costs for homebuilders.
“Although I expect that the housing recovery will resume, the pace will likely be slow, especially relative to past economic recoveries,” Dudley said.
Outside the United States, Dudley held up the tensions between Russia and Ukraine as “one obvious wildcard.”
With respect to the outlook for prices, Dudley sees inflation drifting upwards over the next year, getting closer to the FOMC’s 2% objective.
“That said, I see little prospect of inflation climbing sharply over the next year or two,” he added, “there still are considerable margins of excess capacity available in the economy – especially in the labor market – that should moderate price pressures.”
Dudley also stressed that the FOMC’s inflation target is not a ceiling. He noted that once the target is reached, inflation is likely to spend “as much time slightly above 2% as below it, recognizing that we will hardly ever be exactly at 2% because of the inherent volatility in prices.”
With that in mind, “If inflation were to drift above 2%, all else equal, then we would tend to resist such a rise. But, if inflation were slightly above 2% even as unemployment remained far above levels consistent with maximum employment, then the unemployment consideration would dominate because we would be further from the unemployment objective than we are from the inflation objective,” Dudley said.