Low interest rates may not be a “serious problem” and while tax reform will support near-term growth, it will add to the long-term burdens on the economy, Federal Reserve Bank of New York President William Dudley said Thursday.

He also said his outlook supports continued removal of policy accommodation.

William Dudley
Federal Reserve Bank of New York President William Dudley Bloomberg News

Inflation is likely to rise and hit 2% over the medium term, he said, “Even if inflation were to remain somewhat below 2% over the near future, that might not be a serious problem, if the economy were to continue to perform well in other respects.”

Dudley expects GDP growth in the 2.5% to 2.75% range, which would allow the labor market to tighten “further, pushing up wage inflation and eventually services prices,” Dudley said according to prepared text of a speech at the Securities Industry and Financial Markets Association released by the Fed.

Core personal consumption expenditure prices for the three months ending in November were up 1.8% year-over-year, compared to 0.4% in May, he said. Transitory factors continue to hold inflation down, but “[w]hen these transitory influences drop out of the year-over-year numbers this spring, the inflation rate is likely to move higher.”

Inflation expectations have been stable despite inflation remaining below target. “I would be much more concerned if low inflation outcomes were contributing to a decline in inflation expectations,” Dudley said. “That would make it more difficult to push inflation back toward our 2 percent objective and would increase the risk of getting stuck at the effective lower bound for interest rates following the next economic downturn, which inevitably will come.”

While the short-term outlook is rosy, he said, “Over the longer term, however, I am considerably more cautious about the economic outlook. Keeping the economy on a sustainable path may become more challenging.”

The Tax Cuts and Jobs Act of 2017 “will increase the nation’s longer-term fiscal burden, which is already facing other pressures, such as higher debt service costs and entitlement spending as the baby-boom generation retires,” he stated. “While this does not seem to be a great concern to market participants today, the current fiscal path is unsustainable. In the long run, ignoring the budget math risks driving up longer-term interest rates, crowding out private sector investment and diminishing the country’s creditworthiness. These dynamics could counteract any favorable direct effects the tax package might have on capital spending and potential output.”

Dudley projected the economic growth created by tax reform will be less than the 1% decrease in federal revenues in both 2018 and 2019. “Most importantly, most of the tax cuts accrue to the corporate sector and to higher-income households that have a relatively low marginal propensity to consume,” he said. “This suggests that a significant portion of the tax cuts will be saved, not spent. On the business side, the boost to investment from the lower corporate tax rate and full expensing is likely to be relatively modest.”

If the economy keeps growing at an above trend pace this year, Dudley said, the unemployment rate will drop below 4% and “should lead to further firming of wage growth.”

While some question the link between “tight labor markets and higher inflation,” he said, “I have not lost faith in this relationship.” He pointed to “a discernible firming in the wage inflation trend” and state data showing those “with lower unemployment rates tend to have firmer wage trends. This supports the case that tighter labor markets tend to be associated with higher wage growth.”

Should his outlook prove true, Dudley said, “I will continue to advocate for gradually removing monetary policy accommodation. As I see it, the case for doing so remains strong. While the fact that inflation is below the FOMC’s 2 percent objective argues for patience, I think that is more than offset by an outlook of above-trend growth, driven by accommodative monetary policy and financial conditions as well as an increasingly expansionary fiscal policy.”

He continued, “Moreover, if the labor market were to tighten much further, there would be a greater risk that inflation could rise substantially above our objective. But, let me be clear: A small and transitory overshoot of 2 percent inflation would not be a problem. Were it to occur, it would demonstrate that our inflation target is symmetric, and it would help keep inflation expectations well-anchored around our longer-run objective. In contrast, if inflation were to shoot appreciably above 2 percent for a considerable time, the FOMC would have to adopt a markedly tighter policy stance that would put the economic expansion at risk. In such circumstances, it is unlikely that we would be able to sustain a low level of unemployment and also achieve our inflation objective.”

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