–Retransmitting Story Headlined 13:00 ET Thursday
By Steven K. Beckner
(MNI) – New York Federal Reserve Bank President William Dudley
Thursday said the Fed may have to inject more monetary stimulus if the
economy slows, if unemployment stops dropping, if downside risks
increase or if deflation threatens.
Dudley, who is vice chairman of the Fed’s policymaking Federal Open
Market Committee, did not specify his preferred method of easing in that
event, but said the FOMC could choose between more large scale asset
purchases (‘quantitative easing’) or doing more maturity extension as it
is now doing through so-called ‘Operation Twist.’
Dudley said the European debt crisis and the approaching “fiscal
cliff” of automatic tax hikes and spending cuts pose “significant
downside risks” to a recovery that is already “disappointing” and
“falling short” of the Fed’s objectives.
Even without those downside risks, he said he expects “only slow
progress” toward full employment in prepared remarks to the Council on
Foreign Relations in New York.
At the very least, Dudley suggested, the FOMC may need to keep the
federal funds rate near zero “beyond 2014,” given indications that the
real equilibrium or “neutral” rate of interest has likely fallen from
the 2% assumed in the Taylor monetary policy rule to close to zero.
Dudley said the FOMC has to consider the costs as well as the
benefits of additional easing, but also warned that if the economy were
to stagnate and go into a deflationary spiral, the costs would be much
higher and more difficult to escape than if the economy were to surprise
on the upside.
It would be far easier for the Fed to raise interest rates than to
extricate the country from a Japan-style “liquidity trap,” he said.
Although past balance sheet expansion by the Fed in two previous
rounds of quantitative easing have had an effect equivalent to 150-200
basis points of reductions in the funds rate, it may not be enough if
shock waves from Europe or other factors cause a deterioration in the
U.S. outlook.
Dudley was not predicting or calling for more monetary stimulus,
but outlined the conditions under which it would become necessary.
He began with a gloomy assessment of the economy.
“The U.S. economy is continuing to slowly recover from the
after-effects of the housing boom and bust and the financial crisis,” he
said. “But the recovery has been disappointing. Indeed, when we look
back at economic forecasts made over the past three or four years it is
notable that growth has systematically fallen short of both the Federal
Reserve and private-sector forecasts.”
“Despite what has been an unusually accommodative monetary policy
by historical standards, the economy has grown at only a 2.1% pace over
the last four quarters and the Blue Chip consensus forecast only
anticipates a modest acceleration to a 2.4% rate over the next four
quarters.”
Dudley said the recovery is being retarded by “headwinds,”
including continued household deleveraging; a still “depressed” housing
market beset by the “large shadow inventory” of unsold homes and “tight”
mortgage underwriting standards; the “significant constraint on the
availability of credit to small business;” “restrictive” fiscal policy
at the state and local level, and “uncertainty about how Congress and
the Administration will address the 2013 federal ‘fiscal cliff.'”
He said “some of these headwinds appear to be subsiding,” but that
he expects only a “gradual” strengthening of economic growth and warned,
“significant downside risks remain, especially those related to the
challenges in Europe and how the potential ‘fiscal cliff’ in the United
States will be resolved after the fall elections.”
“Even if these risks do not materialize, I anticipate only slow
progress toward full employment,” he added.
Meanwhile, Dudley saw little cause for concern about higher
inflation, reiterating the FOMC view that recent above-target inflation
is due to “temporary” factors. Those forces are now “fading,” and future
inflation should be “moderate” because of economic slack,
“well-anchored” inflation expectations, and low rates of growth in labor
compensation.
Dudley echoed the FOMC’s expectation that the funds rate will stay
near zero “at least through late 2014.” And he noted that one version of
the Taylor Rule, known as “Taylor 1999,” “implies liftoff in 2014″ if
the New York Fed’s economic forecast is used.
Taylor Rules essentially call for the funds rate to be adjusted
depending on how actual economic growth, employment and inflation
diverge from the central bank’s assumptions about the economy’s
“potential,” the “natural” rate of unemployment and the inflation target.
Taylor Rules also assume a certain “real” interest rate, typically 2%.
The FOMC’s zero to 25 basis point funds rate setting does not
express the full degree of monetary accommodation, Dudley said. “I
estimate that the current balance sheet provides the equivalent of
roughly 150 to 200 additional basis points of federal funds rate
easing.”
“But as time passes, we will come closer to the date when the
balance sheet will begin to be normalized,” he cautioned. “This implies
that the amount of stimulus from the balance sheet will gradually lessen
over time.”
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** MNI **
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