Federal Reserve Bank of New York President William Dudley, one of the country’s most influential monetary policy makers, reiterated the need to continue raising interest rates while conceding that the U.S. central bank’s inflation model may be in for a rethink soon.
“I expect that the U.S. economy will continue to perform quite well, with slightly above-trend growth leading to further gradual tightening of the U.S. labor market," Dudley said Thursday in remarks prepared for a speech in New York. “As this occurs, I would anticipate that wage growth will firm and that price inflation will gradually rise. In response, I expect that we will continue to gradually remove monetary policy accommodation.”
Fed officials are expected to announce the start of a gradual process to shrink their $4.5 trillion balance sheet when the policy-setting Federal Open Market Committee meets Sept. 19-20 in Washington, while keeping interest rates on hold as they debate why a low U.S. unemployment rate is not lifting wages or prices much.
Five months of weak inflation data have cast doubt on their resolve to raise rates again this year. The outlook is also being clouded by Hurricane Harvey’s impact on the Texas economy, coupled with concerns over the damage Hurricane Irma may bring to Florida in the coming days. These have led investors to further reduce the chances of a rate hike in December to roughly one in five, according to the prices of federal funds futures contracts.
Dudley said he didn’t expect Harvey to alter the trajectory of the U.S. economy, while noting publicly for the first time that broader forces may be impeding the traditional link between a tighter labor market and higher inflation, a view some of his colleagues have begun to entertain in recent months.
“I have been surprised by the persistence of the shortfall from the FOMC’s 2 percent long-run objective,” he said. “While some of this year’s shortfall can be explained by one-off factors, such as the sharp fall in prices for cellular phone service, its persistence suggests that more fundamental structural changes may also be playing a role.”
The New York Fed chief cited the “increased ability of prospective buyers to compare prices across different sellers quickly and easily, the shift in retail sales to online channels of distribution from traditional brick-and-mortar stores, and the consequences of these changes on brand loyalty and business pricing power,” adding that he hoped for more clarity on the question “over the coming months.”
While U.S. unemployment of 4.4% last month was only slightly above the 16-year low set in both May and July, inflation has remained beneath the Fed’s 2% target for most of the last five years. Nonetheless, officials raised rates in March and June and forecast another move before year-end in quarterly projections that will be updated later this month.
According to those projections, made in June, Fed officials believe so-called full employment — the level of labor utilization that would keep inflation stable — is consistent with an unemployment rate somewhere between 4.5% and 5%. Dudley’s comments on inflation implied that estimate may come down.
“If it turns out that structural changes have played a significant role, I would generally view this as a positive, rather than negative, development,” he said. “It would imply that the U.S. economy could operate at a higher level of labor resource utilization without generating a troublesome large rise in inflation.”
Dudley said he expects only a “quite modest” impact on financial markets and the economy when the Fed begins to unwind the balance sheet. He added that if asset prices remain buoyant as the central bank continues to tighten, that “may warrant a somewhat steeper policy rate path,” with the caveat that at the moment, “asset valuations are not particularly troublesome given the economic environment.”
