San Francisco Federal Reserve Bank President John Williams Monday predicted the central bank will likely begin hiking interest rates in the next year or so, and cautioned the Fed might not be able to achieve a smooth landing when it begins to withdraw monetary stimulus from the economy.
Speaking alongside Williams during a monetary policy conference at the George W. Bush Presidential Center in Dallas, Texas, Dallas Fed President Richard Fisher stressed the need for the Fed to be careful as one misstep could turn trillions in excess bank reserves into out-of-control inflation.
Williams is not a voter on policymaking Federal Open Market Committee this year, but he said that given the progress being made by the economy, the FOMC has begun to think about the timing of when it will increase the federal funds rate.
That first rate hike will occur “probably in the next year or so,” he said.
Williams also warned that given the size of the Fed’s balance sheet, it will be hard for the central bank to achieve a soft landing when it begins to withdraw the massive amount of stimulus it has injected into the financial system.
“I don’t think it’s going to be easy… it won’t be necessarily smooth,” he said.
At the same time, the Fed has put in a lot of effort so when it is time to raise rates “we can do that,” he added.
Williams argued that inflation “is not the concern” when the exit begins, with the Fed having the tools in place to ensure inflationary pressures don’t build. The Fed is ready to implement its exit strategy “as appropriate,” he said.
Fisher, who is a voter on the FOMC this year, warned if the exit is not managed correctly the inflationary “tinder” that are excess bank reserves held at the Federal Reserve could be lit.
As that money comes back into the economy, Fisher said the key will be for the FOMC to “moderate that influence so that it does not become an inflationary force.”
“We are in unexplored territory,” he warned, and the Fed must control the flow of money so inflation does not go into hyper drive.
Fisher acknowledged there have been some positive benefits from Federal Reserve’s large scale asset purchases, with corporations able to rebuild their balance sheets. However, they are now being impeded by fiscal policy.
“That’s where Congress is holding us back,” Fisher said, warning that fiscal incentives will determine where capital is distributed.
The FOMC has been scaling back its monthly bond purchases by $10 billion at each meeting since December, and Williams said the goal is to taper in a very stable and “very predictable” way so as not to spook markets, noting there has been very little volatility in the financial markets since the process began.
This shows the Fed needs to “double down” on its communications and make it clear how it will act going forward, he said.
With the FOMC promising to keep interest rates low for “a considerable time” after the bond buying program has ended, Fisher said the Fed needs to be careful, noting that with rate being low for almost six years now, “there are certain sectors of the market that have raised some concern.”
Williams agreed the impact of a global low interest rate environment is something the Fed has to take seriously, and it is keeping an eye out to ensure “we are not allowing a bubble to form.”
There are some tradeoffs to having extraordinarily accommodative monetary policy globally, Williams said, which is one reason the asset purchase program is now being wound down. The Fed is not engaging in QE infinity, he said, because of the cost-benefit trade off, as additional purchases could add to financial stability concerns down the road.
While Fisher argued “we have a limited ability” to impact job growth, Williams countered that although the Fed has limited tools to return the economy back to maximum employment, it still has to do what it can within the confines of its mandate while also keeping inflation low.
“It makes sense to have a dual mandate,” Williams argued, as even those countries with a single inflation fighting task still take into consideration how their policies can increase employment and help their respective economies.
Commenting on the current state of the financial markets, Fisher said one thing of concern to him is that “there is no volatility in the markets,” adding he does not think that is “healthy.”
He blamed this on an expectation that interest rates will stay low for a very long time.
As for Williams, “When I look at the stock market today, I don’t see it as being overvalued,” he said, adding the bond market is struggling with “what’s the new normal for interest rates.”
The question they are grappling with, he concluded, is “are we in a future of a slower growing global economy” with a smaller workforce and a drawn out period of low interest rates.