San Francisco Fed President John Williams begs to differ. Though he does not have a vote on the central bank's policy committee this year, his views have been closely aligned with those of Fed Chair Janet L. Yellen. He spoke exclusively to The Washington Post this week about why he believes the central bank should raise rates again this year and how it should handle an economy that appears stuck in low gear. This interview has been edited for length and clarity.
You’ve been pretty bullish in terms of what you expect to see in the economy and therefore are more supportive of a rate hike -- or possibly more than one -- this year. Can you explain to me your optimism?
It’s really in the context of the two goals we have at the Federal Reserve in terms of our monetary policy. It’s about maximum employment and price stability. The data in terms of the labor market have been overall very good. Obviously, the past few months there have been very strong job reports in terms of payroll gains, but we’re also seeing the employment-to-population ratio moved up to a point that I think is consistent with full employment. We’ve seen not only the unemployment rate come below 5 percent, but we’ve also seen the labor force participation rate move to what I see is consistent with its longer-run trend. Everything that we look at, they all have been showing good improvement and also levels that are consistent with being at or very near full employment.
On the inflation front, I see positive signs there, too. One is that core inflation has stabilized around 1.6 percent on the personal consumption expenditures core index. Other measures of inflation have also stabilized around that level. We’re starting to see some improvements in wage growth. The challenge there is that with productivity growth being so modest -- and with overall inflation having run around 1 percent or so in the last year -- even wage gains of 2 ¼ or 2 ½ percent are still actually quite good.
That’s why, if you say I’m optimistic or bullish, it’s really because I'm looking at the underlying trends in the data and the continuing strength in those two major categories, employment and inflation. Where things haven’t been as good is when you look at GDP. Obviously, the arithmetic here is that productivity growth has been really slow.
How does that translate into the appropriate path for monetary policy?
There are a lot of pieces to this. One is you can just look at where we are relative to our goals: We’re at or very close to full employment. That would call for monetary policy being close to neutral. Inflation is still running below our 2 percent goal, and we need to see inflation move back up to 2 percent. I expect that to happen in the next year or two. That would suggest monetary policy still needs to be accommodative.
But then there’s the big question: What is the neutral rate of interest? What’s the normal interest rate that balances the economy to grow? That’s where the slower productivity growth and demographics of slower labor force growth play a role. A nominal fed funds rate of around 3 percent is probably the best estimate of a normal interest rate.
Based on where we are relative to goals, we still need to be accommodative. I still want to see the good, strong labor market continue. I still want to see inflation moving back up to 2 percent. I do want to see monetary policy still having the foot on the gas, not on the brakes.
But we need to continue to execute on the basic strategy that we’ve laid out over the past couple of years, and that’s a gradual path of removing accommodation, taking our foot very gradually off the gas. We’re not getting anywhere close to the brakes here, and I think we can do that in an orderly, systematic way based on the flow of data.
So, just cutting to the chase here, does that gradual path of rate increases include any this year, in your view?
In my view, it does. We’ve been adding enormous policy accommodation over the past several years. As the economy gets closer to its goals, we can again pull our foot off the gas a bit and hopefully execute a nice, soft landing over the next couple of years.
The challenge always is not only responding to your baseline forecasts but taking into account the various risks to the outlook. We think seriously about what’s happening globally. That has led to what I view as a little extra caution, a little more gradual pace of increases than I was thinking a year or so ago. That reflects a data-dependent approach to policy, but at the same time, fundamentally, the outlook hasn’t changed that much. We want to continue with a gradual path of increases. I don’t think that would interfere in any way with our growth continuing. That would not in any way stall the economy. I just think that would be consistent with the positive developments we’ve seen.
In terms of my own view of whether a rate hike makes sense at the upcoming meetings, it would really be based on how are we doing on our dual mandate goals. I don’t necessarily need to see signs that the labor market is continuing to roar ahead and unemployment continuing to plummet. I just need to see a labor market that is at, or even better than, a normal measure of full employment. On the inflation data, I’m just looking for confirmation that the data are continuing to show the inflationary trends are consistent with the outlook that I’ve written down.
I’m definitely not one of those who thinks we should wait until we see inflation get to 2 percent before we raise rates. I think that would put us significantly behind the curve. People say, "What are you worried about? Why not raise rates then?" I think then we would have to raise rates relatively quickly, and I think that abrupt shift in policy could be disruptive. I think it could actually have significant negative implications for the economic growth here and internationally. We know that when U.S. monetary policy shifts directions and moves, it then has repercussions for the global economy, which then feeds back to the U.S. economy. We don’t want to be the source of unneeded disruptions.
And if we wait way too long, there’s risks of imbalances forming in the economy in terms of asset prices and excessive risk-taking that we’ve seen in previous long booms. And there’s always the risk that inflation takes off faster than we expect. I know that we haven’t seen that in recent history, but for those of us who have been studying this a while, that is one of the repercussions that eventually happens.
Back in December, when we saw the first rate hike, the argument that you’re making is the one Yellen made for getting started. But that argument seems to have fallen by the wayside as we saw headwinds from China, from Brexit, you name it. I’m wondering if there’s a reevaluation of whether or not that’s the right way to go.
I would disagree a little bit with your characterization that we’ve given up on that strategy. It’s not just a semantic issue.
The strategy has two elements. Our policy that we laid out given our forecasts and our expectations of where the economy was going is that we’d be gradually raising interest rates over the next few years, moving back to normal. So that’s the broad strategy.
But within that strategy, we’ve been highlighting that this is not a preset course. The specifics of when we raise rates -- the steepness of that slope, if you will -- will depend on progress we make on our objectives and also changes to our outlook.
I would say our strategy has not changed. I would say that what has happened since December is that numerous events have occurred that have made the tactical execution of that strategy flatter in terms of the interest rate path than I was expecting. Because we haven’t taken action to raise rates, it kind of looks like we’ve changed, but I don’t think we have.
Let’s get into the reasons the neutral rate has fallen so much. What do you think could be driving that?
There have been a flurry of research papers, mostly theoretical papers, trying to analyze what are the factors affecting the neutral interest rate in a country, but more important globally. When you have open capital markets, funds will flow cross-border, and you should expect to see neutral interest rates in countries be determined not only by domestic factors but also global factors.
One would be governments accumulating large amounts of reserves coming out of the Asian financial crisis or the global financial crisis. This is what former Fed chair Ben S. Bernanke referred to as the global savings glut, and, of course, the neutral interest rate is the price that equates supply and demand for the global flow of funds between savers and investors. So countries are saving more, and that increases the supply of savings and pushes down the neutral interest rate.
Other arguments are demographics. Slower population growth is probably decreasing demand for investment, pushing down the neutral rate, and an aging population has effects on savings rates. The other one is an increased demand for safe assets. That has pushed up their prices and pushed down their yields relative to other assets. It basically creates a spread between the cost of borrowing for businesses and households and safe assets. The last one, which is more tentative, is the idea that the wealthy, who tend to save a lot, have seen an increase in the amount of income they have, while the lower-income groups tend to not to save as much. As income has moved from one group to the other, not only in the U.S. but other countries, that pushes the supply of savings upwards.
Do you think that the Federal Reserve was nimble enough in recognizing that the neutral rate has fallen. Did the Fed have the right diagnosis at the right time?
I don’t even know the answer today. Seriously. The critique of our work [on the fall in the neutral rate] is that it builds in a lot of these effects that appear to be permanent. Other people say, well, how do we know that? Maybe in the next five years, things will move back to normal. That debate among economists is happening in the academic world and the central banking world. That’s just a very hard thing to know: Is it a persistent headwind emanating from the financial crisis? Or is it something much more permanent?
The important thing was that we were thinking about this. We weren’t blindsided by this issue. We were thinking about it, we had analysis, we were talking about it. People may not have agreed, they may not have found it compelling at the time, but over time, as the data have come in in support of the view that some of this is permanent, you’ve seen shifts in people’s perceptions.
The fact that it happened gradually over time is not a sign that people were making a mistake. Any kind of statistical, data-based approach to seeing whether there was a shift in economic fundamentals is going to require the data to accumulate to build the conviction of change. People have been regularly updating and changing their views based on how the data have evolved. That, to me, is the positive side of the story.
The mistake you can make is just holding onto your beliefs, not being open to the fact that maybe something’s changing, just sticking to your guns until it’s obvious that you were wrong. And that’s when you make a policy mistake.
But it doesn’t really matter whether you think the neutral rate is low because of headwinds or you think it’s permanently low. The policy implication is still the same. It does influence your view about the path of interest rates over the next two or three years -- for sure. But it doesn’t have a first order effect. If you tell me it’s persistent but not permanent, I’m still going to come to those same policy conclusions.
It’s really more about how we think about what the future is going to hold for us. If you’re really convinced the neutral interest rate five years from now is going 4 or 4 ½ percent, I’m not so concerned that we’ll be really constrained in our ability to achieve our goals. If you tell me that the neutral rate is 3 percent or even lower, then we need to think seriously about ways to raise the neutral interest rate through fiscal or other policies. And obviously we have to think in the long term about how to adapt and evolve our strategies just to be better positioned for a very low neutral rate environment. The time to start thinking about that is now.
Monetary policy doesn’t have a lot of room to maneuver when rates are already so low. What other tools do you think are at the Fed’s disposal if fears of another recession come true?
We have the usual suspects: For the U.S., because of the importance of capital markets, capital markets-based tools have proven to be effective. One of those was asset purchases, both of Treasuries, but, most importantly, of mortgage-backed securities. Those had clear, powerful effects on financial conditions. Forward guidance, under certain circumstances, can be a powerful tool.
We have a toolkit that, importantly, we’ve used, so we have confidence in it. We can deploy quickly if we need it. It took a long time between the start of the recession until we really got powerful forward guidance in place. We could act more quickly in the future if we thought it was necessary, either restarting asset purchases or putting in forward guidance. And obviously we can not raise interest rates or cut interest rates.
Any unusual suspects that you guys are considering? Negative rates or helicopter money?
Negative rates are still at the bottom of the stack in terms of net effectiveness. As we’re seeing in Japan and Europe and especially in countries like Switzerland, there are positives but there are also negatives. And for us, these other tools have bigger positives relative to the costs.
From a long-term strategy point of view, if we’re in a low natural rate environment, we really have to think about whether we really want to move to a price level target or a nominal GDP target.
One of the constraints during the last several years was trying to communicate this idea of lower rates for longer. If you have a framework that says we have a price level objective or a nominal GDP objective, you can just point to that. Are there ways to either reformulate or reframe our strategy that would be more conducive to having clearer communication? I think this is a discussion that obviously should be happening in the academic world but also among policymakers.
I’m not advocating that we should do price level targeting. We just need to think harder today, given the challenges we’ve often had in communicating policy, about ways to do this in the future that might be more effective.