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A Yellen ally at the Fed thinks markets should calm down about rate hikes

Source: Federal Reserve Bank of San Francisco

The Federal Reserve rattled Wall Street last week when it seemed to suggest that it could begin raising a key short-term interest rate earlier than investors expected. Wonkblog sat down with San Francisco President John Williams for an exclusive hour-long interview on his outlook for policy and the economy over the next few years.

Williams is considered a bellwether among the central bank’s top officials and worked closely under Fed Chair Janet Yellen when she headed the San Francisco reserve bank. He still believes the first rate hike should not come until the second half of 2015 but acknowledged that a rapidly falling unemployment rate has hastened the timeline for subsequent increases. When will rates return to what the Fed considers a normal level of 4 percent? His answer may surprise you.

The following transcript has been edited for length and clarity.

Q. Let’s start with last week's Fed meeting and the press conference that followed. Chair Yellen seemed to suggest that the first rate hike could come six months after QE ends. Is that a plausible assumption or are markets moving this forward too quickly?

Basically there’s very little change in my view of the underlying momentum in the economy. The one change that did occur since December is that unemployment is definitely lower and has fallen faster than people were anticipating, and it seems that’s going to continue. That’s a positive thing.

In looking forward to where the path of monetary policy needs to be over the next couple years, I haven’t fundamentally changed my policy views. I still completely agree with the FOMC statements from January and March. I see these statements as basically saying the same thing: We’re going to keep interest rates low for quite some time.

In my view, we haven’t changed fundamentally. The statement had to evolve because the unemployment rate came down to 6.5 percent. Sure, you do see in the projections that the committee members forecast a little bit higher average interest rate in 2016, but to me that’s consistent with the fact that unemployment has come down a little bit. As we get toward the end of 2016, sure, we’re maybe normalizing monetary policy out there a little bit more than people thought in December. But that’s not a shift in monetary policy. That’s just a reflection that the economy has gotten a little bit better and interest rates might be just a little higher than people thought before.

In the big picture, the policy hasn’t changed. Any kind of standard way of thinking about monetary policy is, with unemployment lower, then down the road interest rates will normalize a little bit faster. We’re talking again about 2016. There’s no, to my mind, near-term change for monetary policy.

What does a "considerable period" [after ending asset purchases] mean? It’s not specific about a time frame. That was a conscious decision. My view is if the economy evolves the way I expect, I expect us to end the asset purchase program late this year -- when exactly that occurs will depend. I don’t expect us to start raising interest rates until the second half of 2015.

Any interest rates increases we do have in 2015 will be relatively gradual. Similarly for 2016, the central tendency of the group is to have interest rates 2 percent or a little bit above, which again is very low by any standard. In the FOMC statement, we specifically made note of that.

Market perceptions are what they are. But I really don’t see anything of what we said as suggesting that we’re going to tighten monetary policy sooner rather than previously.

Q. Except that you mention the unemployment rate is falling faster than you anticipated. Does that then become an argument for moving the first rate hike a little bit sooner?

Logically, given that the unemployment rate is a little bit lower, that suggests a little bit higher interest rate in 2016. Is that a big shift in the timing of the first rate increase? We’re talking about a relatively small change in terms of the forecast, and I wouldn’t see that as a significant shift.

When I look at the SEP projections for 2015, I just don’t see much of a change in the views on policy -- definitely not the kind of change in views on policy that represents some shift in our policy framework. The fact that unemployment has come down since December a little more than we thought, this is not news. Everybody knows that.

Q. Do you think part of the issue is that to the Fed, let’s say moving in April 2015 versus moving in June 2015 doesn’t seem to be significantly different, in a similar way that starting the taper in September versus December really isn’t a big difference? You’re talking about actually just two months, but the market seems to feel like there’s some major change.

I’m not making any reference to April or June or anything. My expectation is that we would raise rates in the second half, so we’re not talking April. But the point you’re making is a valid one. As economists, we focus on having the right approach to policy. In the big picture, whether it’s at one meeting or the next meeting doesn’t matter nearly as much as getting the general path of policy in the right place. I think that in fact financial markets, once they’ve digested information, that’s the way they process things too.

Whenever we do make any change, participants are trying to divine what else that might mean. With the taper, I was surprised -- and disappointed even -- that the discussion around tapering was misconstrued as a sign of a more hawkish or tighter FOMC. I was thinking no, no, no -- we’re continuing a process that we tried to communicate. The taper is one step in this, but in no way does moving to the next step imply a change in the view of when we’ll start raising interest rates.

I think last year we learned that the communication hasn’t totally been absorbed by people. We put an emphasis on trying to separate those two things out: The taper is one decision, raising interest rates is one. We got back to a good place.

Now the discussion about when we’re going to raise interest rates and the pace at which we’re going to raise interest rates is stirring that same thing: If the Fed is talking about it, maybe they’re going to do it sooner than we thought. I think the lesson is that confusing the two is something that we have to make sure we explain.

My view is let’s just explain ourselves as best we can and not put anything between the lines. We can’t be specific about how we’ll raise interest rates when we eventually do, because we don’t know. It depends on what actually happens.

Q. You mentioned the communications challenge the Fed faced last year in convincing the markets that tapering is not tightening. One of the subtle distinctions I’m hearing now is the difference between zero percent interest rates and low interest rates. It seems like the Fed is now trying to reassure the markets that interest rates will remain low even if they’re not at zero.

What you just said is exactly what I thought we were saying: It’s OK. Eventually we’re going to raise interest rates. Understand that any interest rate increases we do are going to be in the context of a shallow glide path, or a gradual process over what looks like several years before we get back to a normal level.

The view is that we’re going to raise rates relatively gradually, so that at the end of 2016 my own view is that interest rates will be well below 4 percent. Even if 4 percent is the right number -- which, you know, who knows? -- it will take quite a long time before we get to that 4. Of course along the way we’ll be evaluating this and even actually reevaluating whether 4 percent is the right long-run number.

I thought the [FOMC statement] was a very good transition statement from the old thresholds to the qualitative guidance. I think it represents a very good, fair representation of our thinking about policy.

Q. Let’s talk for a moment about Minneapolis Fed President Narayana Kocherlakota’s dissent and his concern that the wording of the Fed’s statement somehow undermined its commitment to reaching its 2 percent inflation target.

I actually value Kocherlakota enormously as a colleague. I think he brings really strong arguments. In the end, I come out at a different place -- but not because we have different goals. The real difference is my concern is that keeping these very strong guideposts like 5.5 percent could actually interfere with our ability to communicate effectively our policy decisions if the world really goes differently than we expect. It’s a difference about tactics, about how best to explain it.

In terms of credibility, I do disagree with that point. I see our policies as achieving our goals over the next few years.

My own interpretations of some of his criticisms is we should get there faster if we can. I think our policies are doing about as well as we can without creating excessive risks down the road, either for the economy or financial stability. I think there is a little bit of a tradeoff between trying to push this economy now even harder and maybe having some unintended consequences down the road -- not today, not next year, probably not the year after -- and also the potential of making the exit out of our very accommodative policies a little more difficult to navigate. I’m confident we can do it, but it’s just going to be difficult.

Q. With Kocherlakota’s dissent and Boston Fed President Eric Rosengren’s dissent in December, it seems there’s been a shift in the debate between the FOMC participants from just hawk versus dove to dove versus dove.

As we’ve moved away from an extraordinary period to a still abnormal period, then I think some of these distinctions between should we do a little bit more or a little bit less start to come up a little bit more. I do agree that it’s natural and appropriate that as we get closer there will be a lot more debates about the tactical aspects of this. I think that’s a healthy thing.

This is not a disagreement about the role or the goals of monetary policy. It’s really more about exactly where do you come out in weighing some costs and benefits. These differences are really within that relatively narrow range. We’re all very supportive of very accommodative, very strong monetary policy.