The U.S. central bank won’t raise rates “for some time” but it is moving toward a more normalized monetary policy, San Francisco Federal Reserve Bank President John Williams said Monday.
“We won’t raise interest rates for some time, which is the real marker of tightening policy,” Williams said in a speech prepared for the Utah and Montana Bankers Associations’ annual meeting in Sun Valley, Idaho. However, he continued, “We’ve already considerably reduced the pace of our asset purchases, which will likely end this year.”
Williams, who was Fed Chair Janet Yellen’s top aide when she led the San Francisco bank, compared the economic crisis to a broken leg. “When you break a leg, you don’t just snap the pieces back into place; you leave the cast on until the bone heals,” he said.
“We’re moving towards normalization, and as the economy continues to improve, we’ll take off the cast,” Williams said. “When it’s able to move on its own, we’ll take away the walking stick.”
“The events of the past several years demanded strong policy action, and we were right to take it,” he added. “But it doesn’t reflect a fundamental shift in our goals or strategy.”
Williams, who will vote on the Federal Open Market Committee in 2015, told the bankers he is upbeat about the outlook for the economy. “In a nutshell, the U.S. economy is looking a lot better these days,” he said.
While there are some “glitches,” such as the drop in GDP in the first quarter, “the evidence points to transitory factors being the main culprit there, such as the terrible weather that afflicted large portions of the country,” he said.
As for growth the rest of the year, Williams said he expects a rebound to moderate growth in the second quarter and for the rest of this year. “I expect real GDP growth to run above 3% for the remainder of the year,” he said. “That’s in no way blisteringly fast, but it is enough to keep the labor market moving in the right direction.”
He pointed to the number of total jobs pushing back up above its pre-recession peak in May, but cautioned that while it is “an important milestone, and I’m optimistic about the outlook,” the labor force “has grown quite a bit since the recession started; we would need to surpass pre-recession numbers to get back to a normal labor market.”
The natural rate of unemployment is around 5.25%, Williams estimates, “so with the current unemployment rate at 6.3%, there’s still a way to go before we’re at full employment.”
And as the economy moves closer to full employment, “I expect inflation to edge up gradually towards 2%,” he said.
Williams expressed some concern about the loss of momentum in the housing market recovery, caused in large part by higher mortgage rates. “House prices have rebounded nicely from post-crash lows, but the gains posted in home sales and construction have not been as strong as hoped,” he said.
But other factors give Williams reason to be optimistic about housing going forward, he said.
“The recession forced a lot of adults to move back home, and as the recovery continues, they’ll move out and buy houses or move into apartments,” he said. “Homes are also still relatively affordable, incomes are rising, and despite last year’s jump in mortgage rates, they’re still low by pre-recession standards.”
In the rest of his he speech, Williams defended the Fed’s unconventional policies of large scale asset purchases and improved forward guidance and tried to counter some common criticism of the Fed’s unconventional policies.
“We’ve avoided deflation and helped the economy start moving back towards normal. The journey’s not complete, but we’re much further down the road than we would have been had we executed an early exit from accommodative policy,” he said.
With the Fed’s balance sheet close to $4.5 trillion today, compared to about $850 billion before the crisis, “there’s no question that our asset-purchase programs have massively expanded the size of the Fed’s balance sheet,” he said.
But, Williams added, “eventually, after we bring rates back up and normalize monetary policy, we’ll have to unwind much of that balance-sheet growth.”
Also, the Fed has “put a lot of thought and effort into ensuring that, once it’s appropriate to normalize the stance of monetary policy, we can raise interest rates as needed, communicate our intentions to the markets, manage the balance sheet over time, and bring us back to full employment without undue inflationary pressures,” he said.
The Fed can now pay interest on reserves held at the Fed, Williams said, “and we have other tools to reduce reserves even with a large balance sheet.”
“This means that the usual process of the money multiplier – whereby ample bank reserves can fuel rapid growth in the money supply – is short-circuited,” he said. These tools mean the Fed can control short-term interest rates as needed to stem any inflationary pressures down the road even with bank reserves approaching $2.7 trillion, he said.
Williams also weighed in on the issue of whether the Fed’s easy money policies is relieving pressure on Congress to fix fiscal concerns. “From an economic perspective, there is reason to worry about the lack of action in Washington,” he said.
“When brinkmanship comes to a head, it creates uncertainty that has real, quantifiable effects,” Williams said pointing to the debt ceiling standoff in 2011, the fiscal cliff of 2012, and the government shutdown last year.
But the “idea that the Fed’s ‘propping up’ of the economy is letting Congress avoid decision-making doesn’t hold,” he said.
“That implies that the only prompt to action would be an economy in freefall, something no one wants,” he said. “Congress has many reasons to act on fiscal policy – not least of which being a growing population and shifting demographics that will see the largest generation in our history moving into old age – and nothing we do to interest rates will alter that reality.”