It’s almost time for the Federal Reserve to stop holding the market’s hand.
That’s the message from John Williams, president of the Federal Reserve Bank of San Francisco, who takes the helm of the central bank’s powerful New York branch on June 18.
In an interview on Tuesday, he said he thinks the time is approaching to phase out forward guidance -- the nearly decade-old practice of pledging continued easy monetary policy. The strategy was used to calm investors in the depths of the financial crisis, and the Fed continues to say rates will remain below levels likely to prevail over the longer run, even as it lifts borrowing costs to prevent overheating.
“We can’t keep talking about policy normalization once we’re around what we think of as a neutral interest rate,” Williams said in Minneapolis, referring to the level of interest rates that neither slows nor speeds up the economy. “So I think this forward guidance, at some point, will be past its shelf life.”
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Williams’ views on this -- and all things monetary policy -- are about to get more important. Together with Chairman Jerome Powell and the Fed vice chairman, the New York Fed president has traditionally been part of a leadership trio that steers the Federal Open Market Committee’s policy options. Williams is a centrist who backs its gradual approach to policy tightening, so his promotion reinforces continuity on the FOMC.
He isn’t alone in thinking that the communication approach might be due an update. The Fed’s most recent minutes showed that some participants suggested that policy would move from easy to neutral or even restraining, which could require revising the Fed’s statement. The language currently states that “the stance of monetary policy remains accommodative” and that “with further gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace.”
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The Fed’s target range for its overnight policy rate is currently 1.5 percent to 1.75 percent, while officials view 2.9 percent as neutral, according to their median estimate in March.
Williams says the best way to move away from the commitments implied by such language in the statement is to explain how the central bank will respond to economic developments.
“We probably need to do more work on communicating our reaction function, and not spending so much time trying to communicate our forward guidance,” he said. That could mean a more explicit explanation of the Fed’s quarterly Summary of Economic Projections, which includes its dot plot forecasts of future interest rates, he said. That probably wouldn’t happen anytime soon.
“In a perfect world, we’d find a way to use our economic projections to come up with a document that explained this in words,” he said. “Right now economic projections are kind of a statistical artifact, and there’s no story to go along with that.”
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The dot plot will be updated at the Fed’s next meeting on June 12-13, at which investors widely expect officials to raise rates for the second time this year. In March, the projections showed three to four hikes in 2018.
Williams said in a speech earlier on Tuesday in Minneapolis that he still thinks three to four rate hikes will probably be appropriate, thanks to a strong economy and solid labor market. He did not see signs that inflation is poised to dramatically overshoot the Fed’s 2 percent goal -- especially because wage growth has been slow to ramp up.
“It is a reason, a serious reason, that I’m not that worried about inflation, or wage inflation, or price inflation, being on the cusp of an outburst,” Williams said during the interview. In a world where inflation expectations have been contained for years, “the kind of wage-price spirals that we saw in the 60’s and 70’s don’t look likely to occur.”
Even as unemployment continues to drop -- falling below 4 percent in April for the first time since 2000 -- and inflation comes in at 2 percent, the outlook is not without hazards. One of those is the potential signal being sent by a flattening yield curve. An inverted yield curve -- when shorter-term borrowing costs rise above long-term ones -- has historically been a harbinger of a recession, and the spread between five- and 30-year Treasuries has recently narrowed to the lowest since 2007.
“Am I worried today about the fact the yield curve is flat? No. Because I think that’s driven primarily by the fact that the Fed is tightening, long rates are moving up, but not surprisingly, not one-for-one,” Williams said. “But I do think that we need to keep our eye on what happens to the yield curve in the next year or two, as we continue to raise interest rates.”
Asked whether he could justify hiking rates if it meant inverting the yield curve, Williams said the exact situation would matter.
“I don’t see that as a situation that we would be running into in the next year or so, but I think the answer to that depends on the context,” he said. “If we’re in a really strong economy with high inflation, then I think you need to have monetary policy to adjust to that.”
At the same time, “I definitely wouldn’t ignore signals we’re getting from the markets.”
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