Jobs, inflation will determine if policy needs to become restrictive, Dudley says

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Inflation and the unemployment rate will determine if monetary policy will need to become restrictive in the coming years, Federal Reserve Bank of New York President William Dudley said Wednesday.

“Whether monetary policy will need to move to a restrictive setting depends crucially on how low the unemployment rate can go without inflation climbing meaningfully above 2%,” Dudley said in a speech at Lehman College in New York, according to prepared text released by the Fed. “Although the jury is still out on this question, last month’s Summary of Economic Projections, or SEP, is instructive. Most FOMC participants — including me — have the unemployment rate moving considerably below their estimate of NAIRU by 2020, with inflation climbing slightly above 2% and the federal funds rate moving above their estimates of its likely long-run value. Thus, the March SEP implies that most FOMC participants expect that monetary policy will need to become slightly restrictive in the years ahead.”

The neutral real interest rate, he estimated, is near 1%, so the federal funds rate target would have to rise to about 3% to hit neutral, where policy is neither accommodative nor restrictive. “Of course, as the factors that influence r-star change, my estimate of r-star will also move around over time,” he said.

Gradual rate increases, therefore, remain appropriate, Dudley said. “It is important to get monetary policy back to a neutral setting before the labor market becomes so tight that wages and prices begin to rise at a pace inconsistent with the FOMC’s 2% inflation objective.”

Fiscal and trade issues add to the uncertainty of what a neutral rate is, “and the possibility that the FOMC will have to move to a restrictive stance,” he added. “The shift in fiscal policy toward stimulus is somewhat challenging because of its timing — it is unusual to move fiscal policy sharply in a stimulative direction at a mature stage of a business cycle — and because the shift puts the nation’s fiscal path on an unsustainable trajectory.”

Addressing talk of raising the inflation target, Dudley said, “I do not support the option of raising the inflation objective, for three reasons.” First, he said, a higher target may not be consistent with the Fed’s price stability mandate.

“Second, the risks of being pinned at the effective lower bound for interest rates may be overstated,” said, since this only happened once in the postwar period.

Finally, he suggested, better options exist to address the “risks associated with the effective lower bound than a higher inflation objective.”

The answer, perhaps, would be an inflation target of 1.5% to 2.5%, but Dudley said, “I would not recommend shifting to such a range currently.”

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Monetary policy William Dudley Federal Reserve Federal Reserve Bank of New York FOMC