This morning I had the opportunity to hear San Francisco Federal Reserve President John Williams present his outlook for the US economy and the implications for monetary policy in Portland. I had anticipated that Williams would be supportive of tapering in the near future, and I was not disappointed.
Williams first catalogues the improvements in the private sector of the economy and, importantly, downplays the recent rise in interest rates:
Recently, longer-term rates have risen as investors prepare for the eventual normalization of monetary policy. But they are still quite low by historical standards.
Obviously, he doesn’t think investors have overreacted to the tapering talk; instead, they have reacted appropriately to the likely path of policy. In other words, Williams is not inclined to delayed tapering due to the market reaction.
Unsurprisingly, Williams notes the disparity between private and public sector activity:
All in all, the private side of the economy has been forging ahead with considerable momentum. But we’re seeing just the opposite with the public sector.
That said, better times lay ahead:
Where will we go from here? GDP adjusted for inflation grew at a modest rate just above 1½ percent over the past year. However, I expect growth to pick up in the second half of 2013 as the drag from the federal budget wanes and momentum in the private sector continues to gather steam. For this year as a whole, I see inflation-adjusted GDP growing about 2 percent, and then rising to about 3 percent in 2014. With the economy continuing to grow and add jobs, I expect the unemployment rate to decline gradually over the next few years.
Nothing to get excited about, but generally consistent with Fed forecasts. What about inflation? Recall that I warned that recent inflation numbers would be met with a sigh of relief. Williams:
I am encouraged, though, by recent data that suggest the declines in inflation over the past year will prove temporary. With the economy continuing to improve, I expect inflation will gradually climb back towards our 2 percent longer-run target over the next few years.
Inflation is also on track with Fed forecasts. What does this mean for monetary policy? Well, the path of monetary policy hinges on the unemployment rate. But is the unemployment rate the appropriate measure of labor market distress? Williams takes us through the pros and cons of alternative measures of labor market slack, which summarizes to:
So should we stop using the unemployment rate as our primary yardstick of the state of the labor market in favor of the employment-to-population ratio? My answer is no. Although the unemployment rate is by no means a perfect measure of labor market conditions, the employment-to-population ratio blurs structural and cyclical influences. That makes it a problematic gauge of the state of the labor market for monetary policy purposes…Of course, we will continue to look at a wide range of indicators when we evaluate labor market conditions. But the preponderance of evidence indicates that the unemployment rate remains the best overall summary statistic.
Williams concludes that the Fed is closer to meeting its test of substantial improvement in the labor market, which, when coupled with his expectation that inflation is also moving toward target, leaves him open to tapering in the near future:
But the time is approaching when our economy will have enough momentum on its own without the need for additional monetary stimulus. This is undeniably welcome news.
To be sure, Williams gives the usual caveats about the pace of tapering being data dependent, but is seems clear that he would favor beginning the tapering process soon while adjusting the pace of future reductions in asset purchases according to the data. Williams also emphasizes the forward guidance:
Even when we eventually halt asset purchases, we will continue to maintain the current very low level of the fed funds rate for at least as long as the unemployment rate is above 6½ percent and the conditions regarding inflation and inflation expectations are met. Based on my current forecast, I don’t expect the economy to reach 6½ percent unemployment until the first half of 2015, and I don’t expect the FOMC to raise rates until later that year.
Interestingly, during the Q&A period, Williams said that if additional accommodation were required in the future, he would prefer that it be accomplished via the forward guidance tool. Not that quantitative easing was not effective, only that forward guidance is more effective, in his opinion. To me, this is important. While the Fed claims they can adjust asset purchases up or down, they don’t really want to adjust them up. Fundamentally, they want to normalize policy, and that shifts their preferences to interest rate tools, including forward guidance. In short, the game is no longer about asset purchases, it’s about the timing of the first rate hike.
In strong contrast lies Minneapolis Federal Reserve President Narayana Kocherlakota. In his opening remarks tonight, Kocherlakota bluntly says:
But current monetary policy is typically thought to affect the macroeconomy with a one- to two-year lag. This means that we should always judge the appropriateness of current monetary policy in terms of what it implies for the futureevolution of inflation and employment. Along those lines, after its most recent meeting, the FOMC announced that it expects that inflation will remain below 2 percent over the medium term and that unemployment will decline only gradually. These forecasts imply that the Committee is failing to provide sufficient stimulus to the economy.
Doesn’t really take any special knowledge of the Federal Reserve to read the message in that statement. Don’t taper; increase asset purchases. Alas, I do not think the policy winds are blowing in Kocherlakota’s direction. The momentum is with the tapering crowd.
Bottom Line: Williams is open to tapering, Kocherlakota opposed. Neither is a voting member of the FOMC, but I suspect the voting members lean toward Williams. Tapering is coming, most likely at the next FOMC meeting. But regardless of the timing of the first tapering move, the real story is now about forward guidance on the timing of the first rate increase.
This piece is cross-posted from Tim Duy’s Fed Watch with permission.